UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q



x	~~QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934~~

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, ~~2017~~2018 or

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



¨	~~TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934~~

For the transition period from __________ to __________

Commission File Number 000-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)



Washington		91-1857900
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

201 Fifth Avenue SW, Olympia, WA		98501
(Address of principal executive offices)		(Zip Code)

(360) 943-1500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨

Indicate by check mark whether the registrant has submitted electronically ~~and posted on its corporate Web site, if any,~~ every Interactive Data File required to be submitted ~~and posted~~ pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit ~~and post~~ such files). Yes ý No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.



	Large accelerated filer	¨		~~Accelerated filer~~	x
~~Non-accelerated filer~~	¨		~~Smaller reporting company~~	¨
~~Emerging Growth Company~~	¨ ý		Accelerated filer ¨
	Non-accelerated filer ¨		Smaller reporting company ¨
			Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ �� No ý

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

As of ~~November 1, 2017~~October 29, 2018 there were ~~29,929,106~~36,873,123 shares of the registrant's common stock, no par value per share, outstanding.

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

~~INDEX~~

September 30, ~~2017~~2018

TABLE OF CONTENTS



				Page
FORWARD LOOKING STATEMENTS

~~Part~~PART I.	FINANCIAL INFORMATION			4
~~Item~~ITEM 1.	FINANCIAL STATEMENTS			4
		~~Condensed Consolidated Statements of Financial Condition as of September~~CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AS OF SEPTEMBER 30, ~~2017 and December~~2018 AND DECEMBER 31, ~~2016~~2017		4
		~~Condensed Consolidated Statements of Income for the Three and Nine Months Ended September~~CONDENSED CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017 ~~and 2016~~		5
		~~Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September~~CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017 ~~and 2016~~		6
		~~Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September~~CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017 ~~and 2016~~		7
		~~Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017 ~~and 2016~~		8
		~~Notes to Condensed Consolidated Financial Statements~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS		10
~~Item~~		NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	10
		NOTE 2.	BUSINESS COMBINATIONS	14
		NOTE 3.	INVESTMENT SECURITIES	17
		NOTE 4.	LOANS RECEIVABLE	20
		NOTE 5.	ALLOWANCE FOR LOAN LOSSES	32
		NOTE 6.	OTHER REAL ESTATE OWNED	36
		NOTE 7.	GOODWILL AND OTHER INTANGIBLE ASSETS	36
		NOTE 8.	JUNIOR SUBORDINATED DEBENTURES	37
		NOTE 9.	REPURCHASE AGREEMENTS	38
		NOTE 10.	OTHER BORROWINGS	38
		NOTE 11.	DERIVATIVE FINANCIAL INSTRUMENTS	39
		NOTE 12.	STOCKHOLDERS’ EQUITY	40
		NOTE 13.	ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME	42
		NOTE 14.	FAIR VALUE MEASUREMENTS	42
		NOTE 15.	STOCK-BASED COMPENSATION	48
		NOTE 16.	CASH REQUIREMENT	51
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			4751
~~Item~~ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			6876
~~Item~~ITEM 4.	CONTROLS AND PROCEDURES			6876

Part II.	OTHER INFORMATION			6876
~~Item~~ITEM 1.	LEGAL PROCEEDINGS			6876
~~Item~~ITEM 1A.	RISK FACTORS			6877
~~Item~~ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			6977
~~Item~~ITEM 3.	DEFAULTS UPON SENIOR SECURITIES			6977
~~Item~~ITEM 4.	MINE SAFETY DISCLOSURES			6977
~~Item~~ITEM 5.	OTHER INFORMATION			6977
~~Item~~ITEM 6.	EXHIBITS			7078
	SIGNATURES			7078

Table of Contents

FORWARD LOOKING STATEMENTS:

~~“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995:~~ This Quarterly Report on Form 10-Q ("Form 10-Q") ~~contains~~may contain forward-looking statements ~~that~~within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks, ~~and~~ uncertainties ~~including, but not limited to: the expected revenues, cost savings, synergies~~ and other ~~benefits~~factors that could cause actual results to differ materially from the results anticipated, including: our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel from our ~~pending merger~~recent mergers with Puget Sound Bancorp, Inc., ~~("Puget Sound") might not be realized~~and Premier Commercial Bancorp, into our operations and our ability to realize related revenue synergies and cost savings within ~~the~~ expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; the proposed Puget Sound merger may not close when expected or at all because required regulatory, shareholder or other approvals and conditions to closing are not received or satisfied on a timely basis or at all or adverse regulatory conditions may be imposed in connection with governmental approvals of the merger; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the ~~Board of Governors of the Federal Reserve System and of our~~ bank ~~subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities,~~regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings; legislative or regulatory ~~changes;~~changes that adversely affect our business including but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III; our ability to control operating costs and expenses; increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; ~~failure~~disruptions, security breaches, or ~~security breach~~other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of ~~computer systems on which we depend;~~our critical processing functions; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our growth strategies; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year ended December 31, ~~2016.~~2017.

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating results and stock price performance.

As used throughout this report, the terms “we”, “our”, “us”, or the “Company” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)

~~(Unaudited)~~(In thousands, except shares)


	September 30, 2017			December 31, 2016
	(Dollars in thousands)						September 30, 2018			December 31, 2017
ASSETS
Cash on hand and in banks	$	82,905		$	77,117		$	120,833		$	78,293
Interest earning deposits	28,353			26,628			49,310			24,722
Cash and cash equivalents	111,258			103,745			170,143			103,015
Investment securities available for sale, at fair value	800,060			794,645			920,737			810,530
Loans held for sale	5,368			11,662			1,882			2,288
Loans receivable, net	2,797,513			2,640,749			3,649,054			2,849,071
Allowance for loan losses	(31,400		)	(31,083		)	(34,475		)	(32,086		)
Total loans receivable, net	2,766,113			2,609,666			3,614,579			2,816,985
Other real estate owned	523			754			2,032			—
Premises and equipment, net	60,457			63,911			80,439			60,325
Federal Home Loan Bank stock, at cost	9,343			7,564			6,076			8,347
Bank owned life insurance	71,474			70,355			93,296			75,091
Accrued interest receivable	12,295			10,925			15,735			12,244
Prepaid expenses and other assets	87,728			79,351			108,730			99,328
Other intangible assets, net	6,408			7,374			21,728			6,088
Goodwill	119,029			119,029			240,837			119,029
Total assets	$	4,050,056		$	3,878,981		$	5,276,214		$	4,113,270
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,320,818		$	3,229,648		$	4,398,127		$	3,393,060
Federal Home Loan Bank advances	117,400			79,600			—			92,500
Junior subordinated debentures	19,936			19,717			20,229			20,009
Securities sold under agreement to repurchase	28,668			22,104			32,233			31,821
Accrued expenses and other liabilities	55,626			46,149			79,492			67,575
Total liabilities	3,542,448			3,397,218			4,530,081			3,604,965
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2017 and December 31, 2016	—			—
Common stock, no par value, 50,000,000 shares authorized; 29,929,106 and 29,954,931 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively	360,113			359,060
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2018 and December 31, 2017							—			—
Common stock, no par value, 50,000,000 shares authorized; 36,873,123 and 29,927,746 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively							591,065			360,590
Retained earnings	145,677			125,309			169,758			149,013
Accumulated other comprehensive income (loss), net	1,818			(2,606		)
Accumulated other comprehensive loss, net							(14,690		)	(1,298		)
Total stockholders’ equity	507,608			481,763			746,133			508,305
Total liabilities and stockholders’ equity	$	4,050,056		$	3,878,981		$	5,276,214		$	4,113,270

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except per share amounts)

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands, except per share amounts)
INTEREST INCOME
Interest and fees on loans $ 32,595
$ 30,915
$ 94,580
$ 91,595
Taxable interest on investment securities 3,117
2,888
9,307
8,522
Nontaxable interest on investment securities 1,354
1,235
3,926
3,599
Interest and dividends on other interest earning assets 258
76
461
225
Total interest income 37,324
35,114
108,274
103,941
INTEREST EXPENSE
Deposits 1,628
1,269
4,301
3,765
Junior subordinated debentures 261
221
748
647
Other borrowings 444
18
908
78
Total interest expense 2,333
1,508
5,957
4,490
Net interest income 34,991
33,606
102,317
99,451
Provision for loan losses 884
1,495
2,882
3,754
Net interest income after provision for loan losses 34,107
32,111
99,435
95,697
NONINTEREST INCOME
Service charges and other fees 4,769
3,630
13,408
10,462
Gain on sale of investment securities, net 44
345
161
1,106
Gain on sale of loans, net 1,229
3,435
6,562
5,406
Interest rate swap fees 328
742
743
1,105
Other income 2,024
1,715
5,532
5,354
Total noninterest income 8,394
9,867
26,406
23,433
NONINTEREST EXPENSE
Compensation and employee benefits 15,823
15,633
48,119
45,652
Occupancy and equipment 3,979
3,926
11,607
11,873
Data processing 2,090
1,943
6,007
5,564
Marketing 933
745
2,545
2,254
Professional services 1,453
830
3,515
2,508
State and local taxes 640
820
1,828
2,031
Federal deposit insurance premium 433
296
1,090
1,316
Other real estate owned, net (88 ) (142 ) (36 ) 330
Amortization of intangible assets 319
359
966
1,057
Other expense 2,373
2,408
7,346
7,079
Total noninterest expense 27,955
26,818
82,987
79,664
Income before income taxes 14,546
15,160
42,854
39,466
Income tax expense 3,922
4,121
11,086
10,441
Net income $ 10,624
$ 11,039
$ 31,768
$ 29,025
Basic earnings per common share $ 0.35
$ 0.37
$ 1.06
$ 0.97
Diluted earnings per common share $ 0.35
$ 0.37
$ 1.06
$ 0.97
Dividends declared per common share $ 0.13
$ 0.12
$ 0.38
$ 0.35



	Three Months Ended September 30,					Nine Months Ended September 30,
	2018		2017			2018		2017
INTEREST INCOME
Interest and fees on loans	$	48,301	$	32,595		$	127,601	$	94,580
Taxable interest on investment securities	4,662		3,117			12,259		9,307
Nontaxable interest on investment securities	1,085		1,354			3,646		3,926
Interest on other interest earning assets	528		209			988		352
Total interest income	54,576		37,275			144,494		108,165
INTEREST EXPENSE
Deposits	3,014		1,628			7,169		4,301
Junior subordinated debentures	330		261			928		748
Other borrowings	136		444			721		908
Total interest expense	3,480		2,333			8,818		5,957
Net interest income	51,096		34,942			135,676		102,208
Provision for loan losses	1,065		884			3,967		2,882
Net interest income after provision for loan losses	50,031		34,058			131,709		99,326
NONINTEREST INCOME
Service charges and other fees	4,824		4,769			14,062		13,408
Gain on sale of investment securities, net	82		44			135		161
Gain on sale of loans, net	706		1,229			2,286		6,562
Interest rate swap fees	—		328			360		743
Other income	2,468		2,073			6,358		5,641
Total noninterest income	8,080		8,443			23,201		26,515
NONINTEREST EXPENSE
Compensation and employee benefits	23,804		15,823			64,492		48,119
Occupancy and equipment	5,020		3,979			14,457		11,607
Data processing	2,343		2,090			7,455		6,007
Marketing	876		933			2,507		2,545
Professional services	2,119		1,453			8,485		3,515
State and local taxes	931		640			2,335		1,828
Federal deposit insurance premium	375		433			1,105		1,090
Other real estate owned, net	18		(88		)	18		(36		)
Amortization of intangible assets	1,114		319			2,705		966
Other expense	2,997		2,373			8,491		7,346
Total noninterest expense	39,597		27,955			112,050		82,987
Income before income taxes	18,514		14,546			42,860		42,854
Income tax expense	3,010		3,922			6,412		11,086
Net income	$	15,504	$	10,624		$	36,448	$	31,768
Basic earnings per common share	$	0.42	$	0.35		$	1.04	$	1.06
Diluted earnings per common share	$	0.42	$	0.35		$	1.04	$	1.06
Dividends declared per common share	$	0.15	$	0.13		$	0.45	$	0.38

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

~~(Unaudited)~~(In thousands)

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands)
Net income $ 10,624
$ 11,039
$ 31,768
$ 29,025
Change in fair value of investment securities available for sale, net of tax of $157, $(570), $2,442 and $4,983, respectively 289
(1,055 ) 4,528
9,223
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(16), $(121), $(57) and $(388), respectively (28 ) (224 ) (104 ) (718 )
Other comprehensive income (loss) 261
(1,279 ) 4,424
8,505
Comprehensive income $ 10,885
$ 9,760
$ 36,192
$ 37,530



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Net income	$	15,504		$	10,624		$	36,448		$	31,768
Change in fair value of investment securities available for sale, net of tax of $(887), $157, $(3,525) and $2,442, respectively	(3,319		)	289			(13,193		)	4,528
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(17), $(16), $(29) and $(57), respectively	(65		)	(28		)	(106		)	(104		)
Other comprehensive (loss) income	(3,384		)	261			(13,299		)	4,424
Comprehensive income	$	12,120		$	10,885		$	23,149		$	36,192

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)

~~(Unaudited)~~(In thousands, except per share amounts)


	Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
	(Dollars in thousands, except per share amounts)
Balance at December 31, 2015	29,975		$	359,451		$	107,960		$	2,559		$	469,970
Restricted stock awards granted, net of forfeitures	111		—			—			—			—
Exercise of stock options (including excess tax benefits from nonqualified stock options)	28		421			—			—			421
Stock-based compensation expense	—		1,367			—			—			1,367
Net excess tax benefits from vesting of restricted stock	—		99			—			—			99
Common stock repurchased	(167	)	(2,887		)	—			—			(2,887		)
Net income	—		—			29,025			—			29,025
Other comprehensive income, net of tax	—		—			—			8,505			8,505
Cash dividends declared on common stock ($0.35 per share)	—		—			(10,488		)	—			(10,488		)
Balance at September 30, 2016	29,947		$	358,451		$	126,497		$	11,064		$	496,012
															Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
Balance at December 31, 2016	29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763		29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763
Restricted stock awards forfeited	(10	)	—			—			—			—			(10	)	—			—			—			—
Exercise of stock options	12		159			—			—			159			12		159			—			—			159
Stock-based compensation expense	—		1,568			—			—			1,568			—		1,568			—			—			1,568
Common stock repurchased	(28	)	(674		)	—			—			(674		)	(28	)	(674		)	—			—			(674		)
Net income	—		—			31,768			—			31,768			—		—			31,768			—			31,768
Other comprehensive income, net of tax	—		—			—			4,424			4,424			—		—			—			4,424			4,424
Cash dividends declared on common stock ($0.38 per share)	—		—			(11,400		)	—			(11,400		)	—		—			(11,400		)	—			(11,400		)
Balance at September 30, 2017	29,929		$	360,113		$	145,677		$	1,818		$	507,608		29,929		$	360,113		$	145,677		$	1,818		$	507,608

Balance at December 31, 2017															29,928		$	360,590		$	149,013		$	(1,298	)	$	508,305
Restricted stock units vested, net of forfeitures of restricted stock awards															29		—			—			—			—
Exercise of stock options															9		118			—			—			118
Stock-based compensation expense															—		2,016			—			—			2,016
Common stock repurchased															(53	)	(1,702		)	—			—			(1,702		)
Net income															—		—			36,448			—			36,448
Other comprehensive loss, net of tax															—		—			—			(13,299		)	(13,299		)
Common stock issued in business combinations															6,960		230,043			—			—			230,043
Cash dividends declared on common stock ($0.45 per share)															—		—			(15,796		)	—			(15,796		)
ASU 2016-01 implementation															—		—			93			(93		)	—
Balance at September 30, 2018															36,873		$	591,065		$	169,758		$	(14,690	)	$	746,133

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

~~(Unaudited)~~(In thousands)


	Nine Months Ended September 30,
	2017			2016			Nine Months Ended September 30,
	(Dollars in thousands)						2018			2017
Cash flows from operating activities:
Net income	$	31,768		$	29,025		$	36,448		$	31,768
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	8,117			9,543
Depreciation of premises and equipment, amortization of securities available for sale, and amortization of discount of junior subordinated debentures							7,538			8,117
Changes in net deferred loan costs, net of amortization	(656		)	(971		)	(38		)	(656		)
Provision for loan losses	2,882			3,754			3,967			2,882
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	8,315			(193		)	4,231			8,315
Stock-based compensation expense	1,568			1,367			2,016			1,568
Net excess tax benefit from exercise of stock options and vesting of restricted stock	—			(119		)
Amortization of intangible assets	966			1,057			2,705			966
Origination of loans held for sale	(82,767		)	(99,513		)	(60,994		)	(82,767		)
Proceeds from sale of loans	91,576			101,574			63,330			91,576
Earnings on bank owned life insurance	(1,108		)	(1,086		)	(1,079		)	(1,108		)
Valuation adjustment on other real estate owned	—			383
Gain on sale of other real estate owned							—			(111		)
Gain on sale of loans, net	(6,562		)	(5,406		)	(2,286		)	(6,562		)
Gain on sale of investment securities, net	(161		)	(1,106		)	(135		)	(161		)
Gain on sale of assets held for sale	(53		)	—			(382		)	(53		)
Gain on sale of other real estate owned, net	(111		)	(173		)
Impairment of assets held for sale							75			—
Loss on sale or write-off of furniture, equipment and leasehold improvements	12			107			31			12
Net cash provided by operating activities	53,786			38,243			55,427			53,786
Cash flows from investing activities:
Loans originated, net of principal payments	(178,800		)	(190,798		)	(93,047		)	(178,800		)
Maturities of other interest earning deposits	—			1,248
Maturities, calls and payments of investment securities available for sale	75,800			94,328			64,625			75,800
Purchase of investment securities available for sale	(101,017		)	(188,164		)	(262,429		)	(101,017		)
Purchase of premises and equipment	(2,221		)	(5,128		)	(21,468		)	(2,221		)
Proceeds from sales of other loans	24,142			12,931			9,993			24,142
Proceeds from sales of other real estate owned	374			2,486			198			374
Proceeds from sales of investment securities available for sale	21,850			94,380			156,946			21,850
Proceeds from sale of assets held for sale	265			—			603			265
Proceeds from redemption of Federal Home Loan Bank stock	21,788			15,416			26,010			21,788
Purchases of Federal Home Loan Bank stock	(23,567		)	(16,356		)	(21,996		)	(23,567		)
Proceeds from sale of premises and equipment	—			659			26			—
Purchase of bank owned life insurance	—			(8,000		)
Capital contribution to low-income housing tax credit partnership	(8,506		)	(3,315		)	(8,269		)	(8,506		)
Net cash received from acquisitions							105,974			—
Net cash used in investing activities	(169,892		)	(190,313		)	(42,834		)	(169,892		)
Cash flows from financing activities:
Net increase in deposits							180,465			91,170
Federal Home Loan Bank advances							541,450			582,500
Repayments of Federal Home Loan Bank advances							(649,950		)	(544,700		)
Common stock cash dividends paid							(15,796		)	(11,400		)
Net (decrease)/increase in securities sold under agreement to repurchase							(50		)	6,564
Proceeds from exercise of stock options							118			159
Repurchase of common stock							(1,702		)	(674		)
Net cash provided by financing activities							54,535			123,619

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Nine Months Ended September 30,
2017 2016
(Dollars in thousands)
Cash flows from financing activities:
Net increase in deposits 91,170
134,134
Federal Home Loan Bank advances 582,500
403,100
Repayments of Federal Home Loan Bank advances (544,700 ) (385,400 )
Common stock cash dividends paid (11,400 ) (10,488 )
Net increase (decrease) in securities sold under agreement to repurchase 6,564
(789 )
Proceeds from exercise of stock options 159
401
Net excess tax benefit from exercise of stock options and vesting of restricted stock —
119
Repurchase of common stock (674 ) (2,887 )
Net cash provided by financing activities 123,619
138,190
Net increase (decrease) in cash and cash equivalents 7,513
(13,880 )
Cash and cash equivalents at beginning of period 103,745
126,640
Cash and cash equivalents at end of period $ 111,258
$ 112,760

Supplemental disclosures of cash flow information:
Cash paid for interest $ 6,024
$ 4,533
Cash paid for income taxes 1,500
9,000

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned $ 32
$ 677
Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale 2,687
—
Investment in low income housing tax credit partnership and related funding commitment 14,267
19,663



	Nine Months Ended September 30,
	2018			2017
Net increase in cash and cash equivalents	67,128			7,513
Cash and cash equivalents at beginning of period	103,015			103,745
Cash and cash equivalents at end of period	$	170,143		$	111,258

Supplemental disclosures of cash flow information:
Cash paid for interest	$	8,717		$	6,024
Cash paid for income taxes	4,647			1,500

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	434		$	32
Transfers of properties held for sale recorded in premises and equipment, net to prepaid expenses and other assets	1,835			2,687
Investment in low income housing tax credit partnership and related funding commitment	—			14,267
Purchase of investment securities available for sale not settled	5,454			—
Business Combinations:
Common stock issued for business combinations	230,043			—
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale	84,846			—
Loans receivable	718,547			—
Other real estate owned	1,796			—
Premises and equipment	3,785			—
Federal Home Loan Bank stock	1,743			—
Accrued interest receivable	2,454			—
Bank owned life insurance	17,116			—
Prepaid expenses and other assets	3,182			—
Other intangible assets	18,345			—
Goodwill	121,808			—
Deposits	(824,602		)	—
Federal Home Loan Bank advances	(16,000		)	—
Securities sold under agreement to repurchase	(462		)	—
Accrued expenses and other liabilities	(8,489		)	—

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


(1)	Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements

(a) Description of Business

Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the ~~FDIC.~~Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 5964 branch offices as of September 30, 2018 located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.

~~On July 26, 2017,~~Effective January 16, 2018, the Company ~~announced~~completed the ~~execution~~acquisition of ~~a definitive agreement to purchase~~ Puget Sound Bancorp, Inc.~~, ("~~ (“Puget ~~Sound"~~Sound”), the holding company offor Puget Sound Bank, ~~a business bank headquartered in downtown~~both of Bellevue, Washington with one branch location and $567.2 million in total assets, $366.6 million in total loans receivables, net and $505.1 million in total deposits as of June 30, 2017. Upon consummation of the merger, the shareholders of (“Puget Sound ~~will own approximately 13.5%~~Merger”) and on July 2, 2018, the Company completed the acquisition of Premier Commercial Bancorp ("Premier Commercial"), the ~~combined~~holding company for Premier Community Bank, both of Hillsboro, Oregon ("Premier Merger"). See Note (2) Business Combinations for additional information on the Puget Sound Merger and the Premier Merger (collectively the "Premier and Puget ~~Sound will be merged into Heritage Bank. For additional information regarding the proposed transaction, see Note (16), Definitive Agreement.~~Mergers").

(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, ~~2016~~2017 (“~~2016~~2017 Annual Form 10-K”). In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, ~~2017~~2018 are not necessarily indicative of the results that may be expected for the year ending December 31, ~~2017.~~2018. In preparing the unaudited Condensed Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates.

The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the ~~2016~~2017 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the ~~2016~~2017 Annual Form 10-K, except for the accounting ~~policies for stock-based compensation~~policy relating to ~~the issuance of restricted stock units, including grants subject to performance-based and market-based vesting conditions,~~revenue from contracts with customers adopted January 1, ~~2017~~2018, as discussed below.

~~Stock-Based Compensation~~Revenue from Contracts with Customers

Compensation cost is recognized for stock options, restricted stock awards and restricted stock units issued to employees and directors, based on the fair value of these awards at the date of grant. Compensation cost is recognized over the requisite service period, generally defined as the vesting period, on a straight-line basis. Compensation cost for restricted stock units with market-based vesting is recognized over the service period to the extent the restricted stock units are expected to vest. With the adoption of FASB Accounting Standards ~~Update ("ASU" or "Update"~~Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”) ~~2016-09~~, as amended, was adopted by the Company on January 1, ~~2017, forfeitures~~2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of business, except for contracts that are ~~recognized~~specifically excluded from its scope. The Company's revenues are primarily composed of interest income on financial instruments, such as ~~they occur.~~

~~The market price~~loans and investment securities, which are excluded from the scope of ASC 606. Descriptions of our revenue-generating activities that are within the scope ASC 606, which are presented in Service Charges and Other Fees and Other Income on the Company’s ~~common stock at the date~~Condensed Consolidated Statement of grant is used to determine the fair value of the restricted stock awards and restricted stock units. The fair value of stock options granted is estimated based on the date of grant using the Black-Scholes-Merton option pricing model. Certain restricted stock unit grantsIncome, are ~~subject to performance-based vesting~~ as ~~well as other approved vesting conditions and~~follows:

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~~cliff vest~~Service Charges on Deposit Accounts: The Company earns fees from its deposit customers from a variety of deposit products and services. Non-transaction based fees such as account maintenance fees and monthly statement fees are considered to be provided to the customer under a day-to-day contract with ongoing renewals. Revenues for these non-transaction fees are earned over the course of a month, representing the period over which the Company satisfies the performance obligation. Transaction-based fees such as non-sufficient fund charges, stop payment charges and wire fees are recognized at the time the transaction is executed as the contract duration does not extend beyond the service performed.

Wealth Management and Trust Services: The Company earns fees from contracts with customers for fiduciary and brokerage activities. Revenues are generally recognized on a monthly basis and are generally based on ~~those conditions, and~~a percentage of the fair value is estimated using a Monte Carlo simulation pricing model. The assumptions used in the Black-Scholes-Merton option pricing model and the Monte Carlo simulation pricing model include the expected termcustomer’s assets under management or based on investment or insurance solutions that are implemented for the ~~valuation date~~customer.

Merchant Processing Services and Debit and Credit Card Fees: The Company earns fees from cardholder transactions conducted through third party payment network providers which consist of (i) interchange fees earned from the remaining contractual term of the award; the risk-free interest rate based on the U.S. Treasury curve at the valuation date of the award; the expected dividend yield based on expected dividends being payablepayment network as a debit card issuer, (ii) referral fee income, and (iii) ongoing merchant fees earned for referring customers to the ~~holders; and~~payment processing provider. These fees are recognized when the ~~expected stock price volatility over the expected term based~~transaction occurs, but may settle on ~~the historical volatility over the equivalent historical term.~~a daily or monthly basis.

(d) Recently Issued Accounting Pronouncements

FASB ASU 2014-09, Revenue from Contracts with Customers, (as amended by FASB ASU 2015-14; FASB ASU 2016-08; FASB ASU 2016-10 and FASB ASU 2016-12), was issued in May 2014. Under this Accounting Standard Update ~~FASB~~("ASU" or "Update"), the Financial Accounting Standards Board ("FASB") created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:

Remove inconsistencies and weaknesses in revenue requirements.

Provide a more robust framework for addressing revenue issues.

Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.

Provide more useful information to users of financial statements through improved disclosure requirements.

Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The ~~original effective date for this Update was deferred in FASB ASU 2015-14 below.~~

~~FASB ASU 2015-14~~, ~~Revenue from Contracts with Customers (Topic 606)~~, was issued in August 2015 and defers the effective date of the above-mentioned FASB ASU 2014-09 for certain entities. Public business entities, certain not-for-profit entities and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is now permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company ~~expects to adopt~~adopted the revenue recognition guidance, as amended, on January 1, 2018 using the modified retrospective approach. A significant amount of the Company’s revenues are derived from ~~net~~ interest income on financial assets, ~~and liabilities,~~ which are excluded from the scope of the amended guidance. With respect to noninterest income and related disclosures, the Company ~~is in its preliminary stages of identifying~~has identified and ~~evaluating~~evaluated the revenue streams and underlying revenue contracts within the scope of the guidance. ~~To date, the~~The Company ~~has~~did not ~~yet identified~~identify any significant changes in the timing of revenue recognition when considering the amended accounting ~~guidance; however,~~guidance. The adoption of the ~~Company’s implementation efforts are ongoing and such assessments may change prior to~~Update did not have a material impact on the ~~January 1, 2018 implementation date. The Company expects to develop processes and procedures to ensure it is fully compliant with these amendments at~~Company's Condensed Consolidated Financial Statements, but the adoption ~~date.~~did change certain disclosure requirements as described in Significant Accounting Policies above.

FASB ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. This Update contains several provisions, including but not limited to 1)(1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; 2)(2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3)(3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and 4)(4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Company adopted this Update is effective January 1, 2018 using the cumulative catch-up transition method. This change resulted in a cumulative adjustment of $93,000 from accumulated other comprehensive loss, net to retained earnings for ~~public entities~~the unrealized gain related to the Company's equity security. The Company's processes and procedures utilized to estimate the fair value of loans receivable and certificate of deposit accounts for ~~fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect the~~disclosure

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requirements were additionally changed due to adoption of this ~~Update will have a significant impact on~~Update. Previously, the ~~Company’s statements~~Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the exit price notion; accordingly, the Company refined its calculation as part of ~~financial condition or income. Management is in the planning stages of developing processes and procedures~~adopting this Update. Prior period information has not been updated to ~~comply~~conform with the ~~disclosures requirements~~new guidance. See the Condensed Consolidated Statements of ~~this Update, which could impact the disclosures the Company makes related to fair value of its financial instruments.~~Stockholders' Equity and Note (14) Fair Value Measurements.

FASB ASU 2016-02, Leases (Topic 842), as amended by ASU 2017-13, 2018-01, 2018-10 and ASU 2018-11, was originally issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a

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lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition. During 2017, management ~~began its evaluation of its leasing contracts and activities. Management is in the initial stages of developing~~developed its methodology to estimate the right-of use assets and lease liabilities. The Company anticipates electing an exclusion accounting policy ~~to not recognize~~for lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to ~~$14.7~~$14.5 million of minimum lease payments under noncancelable operating lease agreements at ~~December 31, 2016.~~September 30, 2018. The Company does not expect the adoption of this ~~amendment~~Update will have a significant impact to its Condensed Consolidated Financial Statements.

~~FASB ASU 2016-08~~, ~~Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations~~, was issued in March 2016 and it clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to principal versus agent considerations. The Update addresses identifying the unit of account and nature of the goods or services as well as applying the control principle and interactions with the control principle. The amendments to the Update do not change the core principle of the guidance. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

~~FASB ASU 2016-09~~, ~~Stock Compensation (Topic 718)~~, issued in March 2016, is intended to simplify several aspects of the accounting for share-based payment award transactions. For public business entities, the guidance is effective for annual periods after December 15, 2016, including interim periods within those annual periods with early adoption permitted. Certain amendments are required to be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Other amendments are applied retroactively (such as presentation of employee taxes paid on the statement of cash flows) or prospectively (such as recognition of excess tax benefits on the income statement). The Company adopted this standard effective January 1, 2017. The Company made an accounting policy election to account for forfeitures as they occur and this change resulted in a cumulative adjustment that was immaterial to all periods presented. Changes to the statement of cash flows have been applied prospectively and the Company recorded excess tax benefits in its income tax expense. Adoption of all other changes under this Update did not have a material impact on the Condensed Consolidated Financial Statements.

~~FASB ASU 2016-10~~, ~~Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing~~, was issued in April 2016 which clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to identifying performance obligations and licensing. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

~~FASB ASU 2016-12~~, ~~Revenue from Contracts with Customers (Topic 606): Narrow-scope Improvements and Practical Expedients~~, was issued in May 2016. The amendments in this Update do not change the core principle of the guidance in Topic 606. Rather, the amendments in this Update affect only the narrow aspects of Topic 606. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

FASB ASU 2016-13, Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions and reasonable and supportable forecasts that affect the collectibility of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected

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credit losses. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB ~~Accounting Standards Codification ("ASC")~~ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for ~~purchased credit impaired ("PCI")~~PCI assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes, internal controls and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the

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magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. During 2017, the Company's management created a CECL steering committee which ~~will begin~~has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has ~~reviewed proposals from several vendors~~selected a vendor to assist the Company in the ~~adoption.~~adoption and has completed the implementation discovery sessions. The CECL steering committee is in the process of selecting appropriate methodologies and refining key data to process through its CECL models. The Company anticipates running parallel models by second quarter 2019.

FASB ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, was issued in August 2016. The Update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. For public business entities, the guidance iswas effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal ~~years. Early adoption is permitted~~years, and must be applied using a retrospective transitional method to each period presented. The Company ~~has evaluated the new guidance and does not anticipate that its adoption of~~adopted this Update on January 1, ~~2018 will~~2018. The adoption did not have a significant impact on its Condensed Consolidated Financial ~~Statements.~~

~~FASB ASU 2017-03~~, ~~Accounting Changes~~Statements as cash proceeds received from the settlement of bank-owned life insurance policies and ~~Error Corrections (Topic 250)~~cash payments for premiums on bank-owned life insurance policies were previously classified as cash inflows and ~~Investments—Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings (SEC Update)~~, was issued in January 2017. The SEC staff view is that a registrant should evaluate FASB ASC Updates that have not yet been adopted to determine the appropriate financial disclosures about the potential material effects of the updates on the financial statements when adopted. If a registrant does not know or cannot reasonably estimate the impact of an update, then in addition to making a statement to that effect, the registrant should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact. The staff expects the additional qualitative disclosures to include a description of the effect of the accounting policies expected to be applied compared to current accounting policies. Also, the registrant should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed. The amendments specifically addressed recent FASB ASC amendments to Topic 326, Financial Instruments - Credit Losses; Topic 842, Leases; and Topic 606, Revenueoutflows, respectively, from ~~Contracts with Customers; although, the amendments apply to any subsequent amendments to guidance~~investing activities in the ~~FASB ASC. The Company adopted the amendments in this Update during the fourth quarter~~Condensed Consolidated Statements of ~~2016 and appropriate disclosures have been included in this Note for each recently issued accounting standard.~~Cash Flows.

FASB ASU 2017-04, Goodwill (Topic 350), was issued in January 2017 and eliminates Step 2 from the goodwill impairment test. Under the amendments, an entity should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The loss recognized, however, should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The Update is effective for annual periods or any interim goodwill impairment tests beginning after December 15, 2019 using a prospective transition method and early adoption is permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.

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FASB ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities was issued in March 2017 and changes the accounting for certain purchased callable debt securities held at a premium to shorten the amortization period for the premium to the earliest call date rather than to the maturity date. Accounting for purchased callable debt securities held at a discount does not change. The discount would continue to amortize to the maturity date. The ~~updated~~Update is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The Company ~~does~~adopted this Update in January 2018. The adoption did not ~~expect the Update will~~ have a material impact on its Condensed Consolidated Financial Statements as the Company had been accounting for premiums as prescribed under this guidance. ~~The Company anticipates early adopting this Update in January 2018.~~

FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update iswas effective for reporting periods beginning after December 15, 2017. The Company adopted the Update on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements because no share-based payment award was modified during the nine months ended September 30, 2018. The Company will apply this Update prospectively for any subsequent modifications of share-based payment awards.

FASB ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income was issued to address the income tax accounting treatment of the stranded tax effects within other comprehensive income due to the prohibition of backward tracing due to an income tax rate change that was initially recorded in other comprehensive income. This issue came about from the enactment of the Tax Cuts and Jobs Act on December 22, 2017 ~~with~~("Tax Cuts and Jobs Act") that changed the Company’s income tax rate from 35% to 21%. The Update changed current accounting whereby an entity may elect to reclassify the stranded tax effect from accumulated other comprehensive income to retained earnings. The Update is effective for periods beginning after December 15, 2018 although early adoption is permitted. The Company early adopted ASU 2018-02 effective December 31, 2017 and elected a portfolio policy to reclassify the stranded tax effects of the change in the federal corporate tax rate of the net unrealized gains on our available-for-sale investment securities from accumulated other comprehensive loss, net to retained earnings.

FASB ASU 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 was issued to provide guidance on the income tax accounting implications of the Tax Cuts

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and Jobs Act, and allows for entities to report provisional amounts for specific income tax effects of the Tax Cuts and Jobs Act for which the accounting under ASC Topic 740 was not yet complete but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under ASC Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this Update with the provisional adjustments as reported in the Consolidated Financial Statements on Form 10-K as of December 31, 2017. As of September 30, 2018, the Company did not incur any adjustments to the provisional recognition.

FASB ASU 2018-13, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, was issued in August 2018 and modifies the disclosure requirements on fair value measurements in Topic 820. The amendments in this Update are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.


(2)	~~Investment Securities~~Business Combinations

During the nine months ended September 30, 2018, the Company completed the acquisitions of Puget Sound Bancorp and Premier Commercial Bancorp. There were no acquisitions completed during the nine months ended September 30, 2017.

Puget Sound:

On July 26, 2017, the Company, along with the Bank, and Puget Sound Bancorp, Inc. and its wholly owned subsidiary bank, Puget Sound Bank, jointly announced the signing of a definitive agreement. The ~~Company’s investment policy~~Puget Sound Merger was effective on January 16, 2018. As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank.

Pursuant to the terms of the Puget Sound Merger, all outstanding Puget Sound restricted stock awards became immediately vested on the acquisition date of the Puget Sound Merger and Puget Sound shareholders received 1.1688 shares of Heritage common stock per share of Puget Sound stock. Heritage issued an aggregate of 4,112,258 shares of its common stock based on the January 12, 2018 closing price of Heritage Common stock of $31.80 for total fair value of common shares issued of $130.8 million and paid cash of $3,000 for fractional shares in the transaction for total consideration paid of $130.8 million. Total consideration includes $851,000 representing 26,741 shares which were forfeited by the Puget Sound shareholders to pay applicable taxes.

During the three and nine months ended September 30, 2018, the Company incurred acquisition-related costs of approximately $67,000 and $5.1 million, respectively, for the Puget Sound Merger. The Company incurred acquisition related costs of $387,000 for the three and nine months ended September 30, 2017 for the Puget Sound Merger.

Premier Commercial:

On March 24, 2018, the Company, along with the Bank, and Premier Commercial Bancorp and its wholly owned subsidiary bank, Premier Community Bank, jointly announced the signing of a definitive agreement. The Premier Merger was effective on July 2, 2018. As of the acquisition date, Premier merged into Heritage and Premier Commercial Bank merged into Heritage Bank.

Pursuant to the terms of the Premier Merger, Premier Commercial shareholders received 0.4863 shares of Heritage common stock in exchange for each share of Premier Commercial common stock based on the closing date price per share of Heritage common stock on June 29, 2018 of $34.85. Heritage issued an aggregate of 2,848,579 shares of its common stock and paid cash of $2,000 for fractional shares in the transaction for total consideration paid of $99.3 million.

During the three and nine months ended September 30, 2018, the Company incurred acquisition-related costs of approximately $3.3 million and $4.0 million, respectively, for the Premier Merger. The Company did not incur acquisition related costs for the three and nine months ended September 30, 2017 for the Premier Merger.

Business Combination Accounting:

The Premier Merger and Puget Sound Merger resulted in $53.3 million and $68.5 million, respectively, of goodwill. This goodwill is ~~designed primarily~~not deductible for tax purposes.

The primary reason for the Premier and Puget Mergers was to ~~provide~~create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and ~~maintain liquidity, generate~~to achieve operational scale and realize efficiencies of a ~~favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities.~~larger combined organization. The mergers constitute business acquisitions as

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defined by FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed. Heritage was considered the acquirer in these transactions. Accordingly, the preliminary estimates of fair values of Premier Commercial and Puget Sound assets, including the identifiable intangible assets, and the assumed liabilities in the Premier Merger and Puget Sound Merger were measured and recorded as of July 2, 2018 and January 16, 2018, respectively. Fair values on the acquisition dates are preliminary and represent management’s best estimates based on available information and facts and circumstances in existence on the acquisition date. Fair values are subject to refinement for up to one year after the closing date of the acquisitions as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation for both mergers by the end of the fourth quarter of 2018 when the valuation of certain matters, including tax-related balances, is complete.

The preliminary fair value estimates of the assets acquired and liabilities assumed in the Premier and Puget Mergers were as follows:



	Premier Merger		Puget Sound Merger
	(In thousands)
Assets
Cash and cash equivalents	$	22,534	$	25,889
Interest earning deposits	3,309		54,247
Investment securities available for sale	4,493		80,353
Loans receivable	330,085		388,462
Other real estate owned	1,796		—
Premises and equipment, net	3,053		732
Federal Home Loan Bank stock, at cost	1,120		623
Bank owned life insurance	10,852		6,264
Accrued interest receivable	1,006		1,448
Prepaid expenses and other assets	1,828		1,354
Other intangible assets	7,075		11,270
Total assets acquired	$	387,151	$	570,642
Liabilities
Deposits	$	318,717	$	505,885
Federal Home Loan Bank advances	16,000		—
Securities sold under agreement to repurchase	462		—
Accrued expenses and other liabilities	5,985		2,504
Total liabilities acquired	$	341,164	$	508,389

Fair value of net assets acquired	$	45,987	$	62,253

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A summary of the net assets purchased and the preliminary estimated fair value adjustments and resulting goodwill recognized from the Premier and Puget Sound Mergers are presented in the following tables. Goodwill represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed.



	Premier Merger			Puget Sound Merger
	(In thousands)
Cost basis of net assets on merger date	$	40,579		$	54,405
Consideration transferred	(99,275		)	(130,773		)
Fair value adjustments:
Investment securities	(135		)	(348		)
Total loans receivable, net	(184		)	1,400
Other real estate owned	(1,017		)	—
Premises and equipment	1,312			(121		)
Other intangible assets	7,075			9,207
Prepaid expenses and other assets	(1,686		)	(2,282		)
Deposits	(310		)	(62		)
Accrued expenses and other liabilities	353			54
Goodwill recognized from the mergers	$	(53,288	)	$	(68,520	)

The operating results of the Company for the three and nine months ended September 30, 2018 include the operating results produced by the net assets acquired in the Premier and Puget Mergers since the July 2, 2018 and January 16, 2018 merger dates. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Premier and Puget Mergers to the Company’s results of operations. The table below presents only the significant results for the acquired businesses since the July 2, 2018 and January 16, 2018 merger dates:



	Premier Merger ⁽¹⁾						Puget Sound Merger⁽¹⁾						Total
	Three Months Ended			Nine Months Ended			Three Months Ended			Nine Months Ended			Three Months Ended			Nine Months Ended
	September 30, 2018
	(In thousands)
Interest income: Interest and fees on loans⁽²⁾	$	5,422		$	5,422		$	5,959		$	16,606		$	11,381		$	22,028
Interest income: Interest and fees on investments ⁽³⁾	39			39			—			59			39			98
Interest income: Other interest earning assets	115			115			—			113			115			228
Interest expense	(232		)	(232		)	(179		)	(503		)	(411		)	(735		)
Provision for loan losses for loans	(150		)	(150		)	(350		)	(900		)	(500		)	(1,050		)
Noninterest income	44			44			110			367			154			411
Noninterest expense ⁽⁴⁾	(5,435		)	(5,435		)	(1,619		)	(9,291		)	(7,054		)	(14,726		)
Net effect, pre-tax	$	(197	)	$	(197	)	$	3,921		$	6,451		$	3,724		$	6,254

⁽¹⁾ The Premier Merger was completed on July 2, 2018. The Puget Sound Merger was completed on January 16, 2018.

⁽²⁾ Includes the accretion of the discount on the purchased loans of $1.9 million and $3.4 million during the three and nine months ended September 30, 2018, respectively.

⁽³⁾ All securities acquired in the Puget Sound Merger were sold with trade date of January 16, 2018 and settlement dates on or before February 14, 2018.

⁽⁴⁾ Excludes certain compensation and employee benefits for management as it is impracticable to determine due to the integration of the operations for this merger. Also includes certain merger-related costs incurred by the Company.

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The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard as the Premier and Puget Mergers are individually and collectively not material to the Company. The Company believes that the historical Premier Commercial and Puget Sound operating results, individually or collectively, are not considered of enough significance to be meaningful to the Company’s results of operations.


(3)	Investment Securities

As a result of the adoption of FASB ASU 2016-01 on January 1, 2018, equity investments (except for investments accounted for under the equity method of accounting) are now measured at fair value, with changes in fair value recognized in earnings. These investments were previously measured at fair value, with changes in fair value recognized in accumulated other comprehensive loss. Accordingly, these securities are no longer classified as investment securities available for sale and their presentation is not comparable to the presentation as of December 31, 2017. See Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements, as well as the Equity Securities section discussed below.

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Available for sale investment securities

(a) Securities by Type and Maturity

The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)									(In thousands)
September 30, 2017
September 30, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	9,464	$	12	$	(73	)	$	9,403	$	84,252	$	51	$	(505	)	$	83,798
Municipal securities	248,420		5,429		(1,043		)	252,806		164,641		887		(1,456		)	164,072
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	275,128		879		(1,646		)	274,361		321,145		207		(9,436		)	311,916
Commercial	214,793		699		(2,209		)	213,283		318,165		162		(9,213		)	309,114
Collateralized loan obligations	6,007		15		—			6,022		967		—		—			967
Corporate obligations	15,583		247		—			15,830		25,639		137		(67		)	25,709
Other securities	27,850		505		—			28,355
Other asset-backed securities										24,543		618		—			25,161
Total	$	797,245	$	7,786	$	(4,971	)	$	800,060	$	939,352	$	2,062	$	(20,677	)	$	920,737

December 31, 2016
December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	1,563	$	6	$	—		$	1,569	$	13,460	$	6	$	(24	)	$	13,442
Municipal securities	237,305		2,427		(2,476		)	237,256		247,358		3,720		(1,063		)	250,015
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	310,391		985		(2,200		)	309,176		282,724		422		(2,935		)	280,211
Commercial	211,259		599		(3,540		)	208,318		219,696		444		(3,061		)	217,079
Collateralized loan obligations	10,505		4		(31		)	10,478		4,561		19		—			4,580
Corporate obligations	16,611		104		(9		)	16,706		16,594		220		(44		)	16,770
Other securities(2)	11,005		156		(19		)	11,142		27,781		652		—			28,433
Total	$	798,639	$	4,281	$	(8,275	)	$	794,645	$	812,174	$	5,483	$	(7,127	)	$	810,530


⁽¹⁾	Issued and guaranteed by U.S. Government-sponsored agencies.


⁽²⁾	Primarily asset-backed securities.

There were no securities classified as trading or held to maturity at September 30, ~~2017~~2018 or December 31, ~~2016~~2017.

The amortized cost and fair value of investment securities available for sale at September 30, ~~2017~~,2018, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.


	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)				(In thousands)
Due in one year or less	$	6,556	$	6,595	$	20,658	$	20,682
Due after one year through five years	121,518		122,740		185,956		183,968
Due after five years through ten years	248,291		248,603		256,795		249,376
Due after ten years	420,835		421,972		475,943		466,711
Investment securities with no stated maturities	45		150
Total	$	797,245	$	800,060	$	939,352	$	920,737

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(b) Unrealized Losses and Other-Than-Temporary Impairments

The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017:


	Less than 12 Months					12 Months or Longer					Total					Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)															(In thousands)
September 30, 2017
September 30, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	6,484	$	(73	)	$	—	$	—		$	6,484	$	(73	)	$	77,217	$	(492	)	$	530	$	(13	)	$	77,747	$	(505	)
Municipal securities	24,415		(362		)	23,629		(681		)	48,044		(1,043		)	61,743		(549		)	27,912		(907		)	89,655		(1,456		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	135,648		(1,111		)	23,937		(535		)	159,585		(1,646		)	139,277		(2,927		)	136,045		(6,509		)	275,322		(9,436		)
Commercial	112,595		(1,478		)	38,099		(731		)	150,694		(2,209		)	142,747		(2,242		)	139,847		(6,971		)	282,594		(9,213		)
Corporate obligations																12,695		(44		)	1,977		(23		)	14,672		(67		)
Total	$	279,142	$	(3,024	)	$	85,665	$	(1,947	)	$	364,807	$	(4,971	)	$	435,733	$	(6,254	)	$	306,311	$	(14,423	)	$	742,044	$	(20,677	)

December 31, 2016
December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies																$	11,436	$	(24	)	$	—	$	—		$	11,436	$	(24	)
Municipal securities	$	90,188	$	(2,476	)	$	—	$	—		$	90,188	$	(2,476	)	39,298		(384		)	26,509		(679		)	65,807		(1,063		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	181,562		(2,148		)	10,854		(52		)	192,416		(2,200		)	175,847		(1,296		)	66,380		(1,639		)	242,227		(2,935		)
Commercial	157,055		(3,446		)	12,597		(94		)	169,652		(3,540		)	75,121		(700		)	90,822		(2,361		)	165,943		(3,061		)
Collateralized loan obligations	2,976		(1		)	2,969		(30		)	5,945		(31		)
Corporate obligations	4,032		(9		)	—		—			4,032		(9		)	3,472		(44		)	—		—			3,472		(44		)
Other securities	6,998		(19		)	—		—			6,998		(19		)
Total	$	442,811	$	(8,099	)	$	26,420	$	(176	)	$	469,231	$	(8,275	)	$	305,174	$	(2,448	)	$	183,711	$	(4,679	)	$	488,885	$	(7,127	)

⁽¹⁾ Issued and guaranteed by U.S. Government-sponsored agencies.

The Company has evaluated these investment securities available for sale as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017 and has determined that the decline in their value is ~~temporary.~~not other-than-temporary. The unrealized losses are primarily due to increases in market interest ~~rates and larger spreads in the market for mortgage-related products.~~rates. The fair value of these securities is expected to recover as the securities approach their maturity ~~date and/or as the pricing spreads narrow on mortgage-related securities.~~date. None of the underlying issuers of the municipal securities and corporate obligations had credit ratings that were below investment grade levels at September 30, ~~2017~~2018 or December 31, ~~2016.~~2017. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.

For the three and nine months ended September 30, ~~2017~~2018 and ~~2016,~~2017, there were no ~~investment securities determined~~other-than-temporary charges recorded to ~~be other-than-temporarily impaired.~~net income.

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The following table presents the gross realized gains and losses on the sale of securities available for sale for the three and nine months ended September 30, 2018 and 2017.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
	(In thousands)
Gross realized gains	$	145		$	75		$	267		$	192
Gross realized losses	(63		)	(31		)	(132		)	(31		)
Net realized gains	$	82		$	44		$	135		$	161

~~(c)~~

(d) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at September 30, ~~2017~~2018 and December 31, ~~2016~~2017:


	September 30, 2017				December 31, 2016				September 30, 2018				December 31, 2017
	Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)								(In thousands)
Washington and Oregon state to secure public deposits	$	40,997	$	40,772	$	214,834	$	215,247	$	194,052	$	189,917	$	206,377	$	206,425
Repurchase agreements	12,620		12,724		29,481		29,294		46,097		44,706		48,750		48,237
Other securities pledged	201,783		203,482		3,557		3,546		21,237		20,571		12,484		12,498
Total	$	255,400	$	256,978	$	247,872	$	248,087	$	261,386	$	255,194	$	267,611	$	267,160

Equity Securities

The Company holds an equity security with a readily determinable fair value of $132,000 and $146,000 as of September 30, 2018 and December 31, 2017, respectively. As a result of the adoption of FASB ASU 2016-01, this security is no longer classified as an investment security available for sale and has been reclassified to prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition as of September 30, 2018. As such, its presentation is not comparable to the presentation as of December 31, 2017. The Company recorded the tax-effected unrealized gain on the equity security through an adjustment to accumulated other comprehensive loss, net and retained earnings in the Condensed Consolidated Statement of Stockholders' Equity during the nine months ended September 30, 2018.


~~(3)~~(4)	Loans Receivable

The Company originates loans in the ordinary course of business and has also acquired loans through ~~FDIC-assisted~~mergers and ~~open bank transactions.~~acquisitions. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred fees or costs because they are insignificant.

Loans acquired in a business combination are further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.

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(a) Loan Origination/Risk Management

The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and ~~potential problem~~criticized loans. The Company also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.

A discussion of the risk characteristics of each loan portfolio segment is as follows:

Commercial Business:

There are three significant classes of loans in the commercial business portfolio segment: commercial and industrial, owner-occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate classes are both considered commercial real estate loans. As the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.

Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Commercial and industrial loans carry more risk than other loans because the borrowers’ cash flow is less predictable, and in the event of a default, the amount of loss is potentially greater and more difficult to quantify because the value of the collateral securing these loans may fluctuate, may be uncollectible, or may be obsolete or of limited use, among other things.

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Commercial real estate. The Company originates commercial real estate loans primarily within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans in that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate properties. Commercial real estate lending typically involves higher loan principal amounts and payments on loans, and repayment is dependent on successful operation and management of the properties. The value of the real estate securing these loans can be adversely affected by conditions in the real estate market or the economy. There is little difference in risk between owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans.

One-to-Four Family Residential:

The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of maturity typically range from 15 to 30 years. The Company sells most of its single-family loans in the secondary market and retains a smaller portion in its loan portfolio.

Real Estate Construction and Land Development:

The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often

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involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.

Consumer:

The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.

The Company also originates indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its purchase of indirect loans primarily to dealerships that are established and well-known in their market areas and to applicants that are not classified as sub-prime.

~~Table of Contents~~

Loans receivable at September 30, ~~2017~~2018 and December 31, ~~2016~~2017 consisted of the following portfolio segments and classes:


	September 30, 2017			December 31, 2016			September 30, 2018			December 31, 2017
	(In thousands)						(In thousands)
Commercial business:
Commercial and industrial	$	665,582		$	637,773		$	861,530		$	645,396
Owner-occupied commercial real estate	602,238			558,035			785,416			622,150
Non-owner occupied commercial real estate	930,188			880,880			1,283,160			986,594
Total commercial business	2,198,008			2,076,688			2,930,106			2,254,140
One-to-four family residential	81,422			77,391			96,333			86,997
Real estate construction and land development:
One-to-four family residential	51,451			50,414			107,148			51,985
Five or more family residential and commercial properties	122,981			108,764			120,787			97,499
Total real estate construction and land development	174,432			159,178			227,935			149,484
Consumer	340,643			325,140			391,283			355,091
Gross loans receivable	2,794,505			2,638,397			3,645,657			2,845,712
Net deferred loan costs	3,008			2,352			3,397			3,359
Loans receivable, net	2,797,513			2,640,749			3,649,054			2,849,071
Allowance for loan losses	(31,400		)	(31,083		)	(34,475		)	(32,086		)
Total loans receivable, net	$	2,766,113		$	2,609,666		$	3,614,579		$	2,816,985

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within its primary market areas which are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The majority of the Company’s loan portfolio consists of (in order of balances at September 30, ~~2017)~~2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of September 30, ~~2017~~2018 and December 31, ~~2016~~,2017, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

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As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 10. A description of the general characteristics of the risk grades is as follows:

Grades 1 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financial information and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.

Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.

Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

~~Table of Contents~~

Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.

Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for the amount considered uncollectible.

Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

Numerical loan grades for loans are established at the origination of the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. The Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the outstanding principal balances are generally charged-off to the realizable value.

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The following tables present the balance of the loans receivable by credit quality indicator as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017.


	September 30, 2017										September 30, 2018
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	625,387	$	11,067	$	29,128	$	—	$	665,582	$	797,284	$	15,793	$	48,453	$	—	$	861,530
Owner-occupied commercial real estate	576,313		8,305		17,620		—		602,238		745,548		21,260		18,608		—		785,416
Non-owner occupied commercial real estate	897,677		15,790		16,721		—		930,188		1,256,115		12,889		14,156		—		1,283,160
Total commercial business	2,099,377		35,162		63,469		—		2,198,008		2,798,947		49,942		81,217		—		2,930,106
One-to-four family residential	79,882		—		1,540		—		81,422		95,023		—		1,310		—		96,333
Real estate construction and land development:
One-to-four family residential	48,101		273		3,077		—		51,451		105,703		261		1,184		—		107,148
Five or more family residential and commercial properties	121,854		722		405		—		122,981		120,733		54		—		—		120,787
Total real estate construction and land development	169,955		995		3,482		—		174,432		226,436		315		1,184		—		227,935
Consumer	335,073		—		5,045		525		340,643		386,566		—		4,193		524		391,283
Gross loans receivable	$	2,684,287	$	36,157	$	73,536	$	525	$	2,794,505	$	3,506,972	$	50,257	$	87,904	$	524	$	3,645,657


	December 31, 2016										December 31, 2017
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	601,273	$	5,048	$	31,452	$	—	$	637,773	$	597,697	$	19,536	$	28,163	$	—	$	645,396
Owner-occupied commercial real estate	532,585		4,437		21,013		—		558,035		595,455		12,668		14,027		—		622,150
Non-owner occupied commercial real estate	841,383		14,573		24,924		—		880,880		955,450		10,494		20,650		—		986,594
Total commercial business	1,975,241		24,058		77,389		—		2,076,688		2,148,602		42,698		62,840		—		2,254,140
One-to-four family residential	76,020		—		1,371		—		77,391		85,762		—		1,235		—		86,997
Real estate construction and land development:
One-to-four family residential	44,752		500		5,162		—		50,414		49,925		537		1,523		—		51,985
Five or more family residential and commercial properties	105,723		1,150		1,891		—		108,764		96,404		707		388		—		97,499
Total real estate construction and land development	150,475		1,650		7,053		—		159,178		146,329		1,244		1,911		—		149,484
Consumer	320,140		—		5,000		—		325,140		349,590		—		4,976		525		355,091
Gross loans receivable	$	2,521,876	$	25,708	$	90,813	$	—	$	2,638,397	$	2,730,283	$	43,942	$	70,962	$	525	$	2,845,712

Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017 were ~~$84.1~~$105.7 million and ~~$87.8~~$83.5 million, respectively. ~~The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces~~

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~~the Company's credit exposure, was $1.7 million and $1.1 million as of~~ ~~September 30, 2017~~ ~~and~~ ~~December 31, 2016, respectively.~~

(d) Nonaccrual Loans

Nonaccrual loans, segregated by segments and classes of loans, were as follows as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017:

September 30, 2017 December 31, 2016
(In thousands)
Commercial business:
Commercial and industrial $ 4,056
$ 3,531
Owner-occupied commercial real estate 3,720
3,728
Non-owner occupied commercial real estate 1,907
1,321
Total commercial business 9,683
8,580
One-to-four family residential 84
94
Real estate construction and land development:
One-to-four family residential 869
2,008
Consumer 316
227
Nonaccrual loans $ 10,952
$ 10,909

~~The Company had $2.5 million and $2.8 million of nonaccrual loans guaranteed by governmental agencies at September 30, 2017 and December 31, 2016, respectively.~~



	September 30, 2018		December 31, 2017
	(In thousands)
Commercial business:
Commercial and industrial	$	5,918	$	3,110
Owner-occupied commercial real estate	5,565		4,090
Non-owner occupied commercial real estate	2,004		1,898
Total commercial business	13,487		9,098
One-to-four family residential	74		81
Real estate construction and land development:
One-to-four family residential	1,076		1,247
Consumer	143		277
Nonaccrual loans	$	14,780	$	10,703

PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under FASB ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its contractual terms.

(e) Past due loans

The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.

The balances of past due loans, segregated by segments and classes of loans, as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017 were as follows:


	September 30, 2017										September 30, 2018
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	790	$	1,014	$	1,804	$	663,778	$	665,582	$	685	$	1,946	$	2,631	$	858,899	$	861,530
Owner-occupied commercial real estate	498		1,270		1,768		600,470		602,238		1,666		1,385		3,051		782,365		785,416
Non-owner occupied commercial real estate	—		2,085		2,085		928,103		930,188		1,985		1,103		3,088		1,280,072		1,283,160
Total commercial business	1,288		4,369		5,657		2,192,351		2,198,008		4,336		4,434		8,770		2,921,336		2,930,106
One-to-four family residential	—		—		—		81,422		81,422		—		—		—		96,333		96,333
Real estate construction and land development:
One-to-four family residential	1,038		309		1,347		50,104		51,451		—		309		309		106,839		107,148
Five or more family residential and commercial properties	366		—		366		122,615		122,981		—		—		—		120,787		120,787
Total real estate construction and land development	1,404		309		1,713		172,719		174,432		—		309		309		227,626		227,935
Consumer	1,738		657		2,395		338,248		340,643		1,445		—		1,445		389,838		391,283
Gross loans receivable	$	4,430	$	5,335	$	9,765	$	2,784,740	$	2,794,505	$	5,781	$	4,743	$	10,524	$	3,635,133	$	3,645,657

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	December 31, 2016										December 31, 2017
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	2,687	$	1,733	$	4,420	$	633,353	$	637,773	$	2,993	$	1,172	$	4,165	$	641,231	$	645,396
Owner-occupied commercial real estate	1,807		2,915		4,722		553,313		558,035		1,277		1,225		2,502		619,648		622,150
Non-owner occupied commercial real estate	733		—		733		880,147		880,880		870		3,314		4,184		982,410		986,594
Total commercial business	5,227		4,648		9,875		2,066,813		2,076,688		5,140		5,711		10,851		2,243,289		2,254,140
One-to-four family residential	523		—		523		76,868		77,391		513		—		513		86,484		86,997
Real estate construction and land development:
One-to-four family residential	90		2,008		2,098		48,316		50,414		84		1,331		1,415		50,570		51,985
Five or more family residential and commercial properties	—		377		377		108,387		108,764		40		—		40		97,459		97,499
Total real estate construction and land development	90		2,385		2,475		156,703		159,178		124		1,331		1,455		148,029		149,484
Consumer	2,292		105		2,397		322,743		325,140		1,939		687		2,626		352,465		355,091
Gross loans receivable	$	8,132	$	7,138	$	15,270	$	2,623,127	$	2,638,397	$	7,716	$	7,729	$	15,445	$	2,830,267	$	2,845,712

There were no loans 90 days or more past due that were still accruing interest as of September 30, ~~2017~~2018 or December 31, ~~2016,~~2017, excluding PCI loans.

(f) Impaired loans

Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017 are set forth in the following tables.


	September 30, 2017										September 30, 2018
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance		Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	3,131	$	8,581	$	11,712	$	12,060	$	1,254	$	2,409	$	11,821	$	14,230	$	14,738	$	1,711
Owner-occupied commercial real estate	1,082		4,676		5,758		6,068		767		1,566		11,315		12,881		12,907		1,825
Non-owner occupied commercial real estate	4,749		6,034		10,783		10,927		895		4,484		5,863		10,347		10,483		739
Total commercial business	8,962		19,291		28,253		29,055		2,916		8,459		28,999		37,458		38,128		4,275
One-to-four family residential	—		304		304		311		96		—		285		285		297		80
Real estate construction and land development:
One-to-four family residential	1,347		—		1,347		2,305		—		767		309		1,076		1,838		6
Five or more family residential and commercial properties	—		658		658		658		39
Total real estate construction and land development	1,347		658		2,005		2,963		39		767		309		1,076		1,838		6
Consumer	160		274		434		457		60		—		410		410		398		113
Total	$	10,469	$	20,527	$	30,996	$	32,786	$	3,111	$	9,226	$	30,003	$	39,229	$	40,661	$	4,474

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December 31, 2016

Recorded
Investment With
No Specific
Valuation
Allowance

Recorded
Investment With
Specific
Valuation
Allowance

Total
Recorded
Investment

Unpaid
Contractual
Principal
Balance

Related
Specific
Valuation
Allowance
(In thousands)
Commercial business:
Commercial and industrial $ 1,739
$ 10,636
$ 12,375
$ 13,249
$ 1,199
Owner-occupied commercial real estate 1,150
3,574
4,724
5,107
511
Non-owner occupied commercial real estate 4,905
6,413
11,318
11,386
797
Total commercial business 7,794
20,623
28,417
29,742
2,507
One-to-four family residential —
321
321
325
97
Real estate construction and land development:
One-to-four family residential 2,243
828
3,071
3,755
6
Five or more family residential and commercial properties —
1,079
1,079
1,079
60
Total real estate construction and land development 2,243
1,907
4,150
4,834
66
Consumer 48
262
310
325
64
Total $ 10,085
$ 23,113
$ 33,198
$ 35,226
$ 2,734

~~The Company had governmental guarantees of $3.9 million and $3.5 million related to the impaired loan balances at~~ ~~September 30, 2017~~ ~~and~~ ~~December 31, 2016, respectively.~~



	December 31, 2017
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	2,127	$	9,872	$	11,999	$	12,489	$	1,326
Owner-occupied commercial real estate	2,452		4,356		6,808		7,054		621
Non-owner occupied commercial real estate	4,722		11,297		16,019		16,172		1,222
Total commercial business	9,301		25,525		34,826		35,715		3,169
One-to-four family residential	—		299		299		308		93
Real estate construction and land development:
One-to-four family residential	938		309		1,247		2,200		2
Five or more family residential and commercial properties	—		645		645		645		37
Total real estate construction and land development	938		954		1,892		2,845		39
Consumer	160		282		442		466		54
Total	$	10,399	$	27,060	$	37,459	$	39,334	$	3,355

The average recorded investment of impaired loans for the three and nine months ended September 30, ~~2017~~2018 and ~~2016~~2017 are set forth in the following table.


	Three Months Ended September 30,				Nine Months Ended September 30,				Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016		2018		2017		2018		2017
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	11,171	$	9,625	$	11,190	$	9,750	$	16,252	$	11,171	$	15,258	$	11,190
Owner-occupied commercial real estate	5,289		4,553		5,049		4,560		12,533		5,289		12,687		5,049
Non-owner occupied commercial real estate	11,037		12,107		11,198		12,232		10,265		11,037		10,311		11,198
Total commercial business	27,497		26,285		27,437		26,542		39,050		27,497		38,256		27,437
One-to-four family residential	307		265		312		267		288		307		292		312
Real estate construction and land development:
One-to-four family residential	2,157		3,177		2,530		3,253		1,080		2,157		1,139		2,530
Five or more family residential and commercial properties	860		1,619		967		1,746		—		860		161		967
Total real estate construction and land development	3,017		4,796		3,497		4,999		1,080		3,017		1,300		3,497
Consumer	346		885		328		907		396		346		403		328
Total	$	31,167	$	32,231	$	31,574	$	32,715	$	40,814	$	31,167	$	40,251	$	31,574

For the three and nine months ended September 30, ~~2017~~2018 and ~~2016,~~2017, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three and nine months ended September 30, 2018, the Bank recorded $361,000 and $1.0 million, respectively, of interest income related to performing TDR loans. For the three and nine months ended September 30, 2017, the Bank recorded $366,000 and $1.0 million, respectively, of interest income related to performing TDR loans. ~~For the~~

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~~three and nine months ended September 30, 2016, the Bank recorded $156,000 and $501,000, respectively, of interest income related to performing TDR loans.~~

(g) Troubled Debt Restructured Loans

A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. ~~TDRs~~TDR loans are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status. The Company has more stringent definitions of concessions and impairment measures for PCI loans as these loans have known credit deterioration and are generally accreting income at a lower discounted rate as compared to the contractual note rate based on the guidance of FASB ASC 310-30.

The majority of the Bank’s TDR loans are a result of granting extensions of maturity on troubled credits which have already been adversely classified. The Bank grants such extensions to reassess the borrower’s financial status and to develop a plan for repayment. The second most prevalent concessions are certain modifications with extensions that also include interest rate reductions. Certain ~~TDRs~~TDR loans were additionally re-amortized over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Bank.

The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDR loans, the loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for loan losses on ~~TDRs~~TDR loans using the same guidance as used for other impaired loans.

The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017 were as follows:


	September 30, 2017				December 31, 2016				September 30, 2018				December 31, 2017
	Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs
	(In thousands)								(In thousands)
TDR loans	$	20,044	$	5,903	$	22,288	$	6,900	$	24,449	$	6,461	$	26,757	$	5,193
Allowance for loan losses on TDR loans	2,136		555		1,965		437		2,237		713		2,635		379

The unfunded commitment to borrowers related to ~~TDRs~~TDR loans was ~~$160,000~~$1.3 million and ~~$249,000~~$1.2 million at September 30, ~~2017~~2018 and December 31, ~~2016~~2017, respectively.

Loans that were modified as TDR loans during the three and nine months ended September 30, 2018 and 2017 are set forth in the following table:



	Three Months Ended September 30,
	2018			2017
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	11	$	2,352	4	$	1,353
Owner-occupied commercial real estate	2	1,081		2	1,299
Non-owner occupied commercial real estate	2	2,776		1	655
Total commercial business	15	6,209		7	3,307
Consumer	1	25		4	52
Total loans modified as TDR loans	16	$	6,234	11	$	3,359

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~~Loans that were modified as TDRs during the three and nine months ended September 30, 2017 and 2016 are set forth in the following tables:~~

Three Months Ended September 30,
2017 2016

Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
Number of
Contracts
(1)

Outstanding
Principal Balance
(1)(2)
(Dollars in thousands)
Commercial business:
Commercial and industrial 4
$ 1,353
8
$ 2,324
Owner-occupied commercial real estate 2
1,299
2
576
Non-owner occupied commercial real estate 1
655
1
818
Total commercial business 7
3,307
11
3,718
Real estate construction and land development:
One-to-four family residential —
—
5
2,274
Five or more family residential and commercial properties —
—
1
1,606
Total real estate construction and land development —
—
6
3,880
Consumer 4
52
2
26
Total TDR loans 11
$ 3,359
19
$ 7,624


	Nine Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2018			2017
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)
	(Dollars in thousands)						(Dollars in thousands)
Commercial business:
Commercial and industrial	13	$	5,564	15	$	2,915	22	$	4,445	13	$	5,564
Owner-occupied commercial real estate	3	1,351		2	576		3	1,639		3	1,351
Non-owner occupied commercial real estate	2	1,596		1	818		3	2,976		2	1,596
Total commercial business	18	8,511		18	4,309		28	9,060		18	8,511
Real estate construction and land development:
One-to-four family residential	2	1,038		5	2,274		2	767		2	1,038
Five or more family residential and commercial properties	—	—		1	1,606
Total real estate construction and land development	2	1,038		6	3,880		2	767		2	1,038
Consumer	5	60		6	70		8	133		5	60
Total TDR loans	25	$	9,609	30	$	8,259	38	$	9,960	25	$	9,609


⁽¹⁾	Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may have been paid-down or charged-off during the three and nine months ended September 30, ~~2017~~2018 and ~~2016.~~2017.

⁽²⁾

Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification)., except when the modification was the initial advance on a one-to-four family residential real estate construction and land development loan under a master guidance line. There were no advances on these types of loans during the three and nine months ended September 30, 2018 and 2017.

~~Of the 11 loans modified during the three months ended~~The related specific valuation allowance at September 30, ~~2017, seven~~2018 for loans ~~with a total outstanding principal balance of $2.1 million had no prior modifications. Of the 25~~that were modified as TDR loans ~~modified during the nine months~~

~~Table of Contents~~

ended September 30, 2017, 15 loans with a total outstanding principal balance of $5.0 million had no prior modifications. Of the 19 loans modified during the three months ended September 30, 2016, eight loans with a total outstanding principal balance of $1.4 million had no prior modifications. Of the 30 loans modified during the nine months ended September 30, ~~2016, 15 loans with a total outstanding principal balance of $1.7 million had no prior modifications. The remaining~~2018 was $1.0 million. Certain loans included in the ~~table~~tables above ~~for the three and nine months ended September 30, 2017 and 2016 were~~may have been previously reported as ~~TDRs.~~TDR loans. The Bank typically grants shorter extension periods to continually monitor these ~~TDRs~~TDR loans despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The ~~Company~~Bank does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR loan and are adjusted, as necessary, in the current period based on more recent information. ~~The related specific valuation allowance at September 30, 2017 was $1.1 million for loans that were modified as TDRs during the nine months ended September 30, 2017.~~

There was one commercial and industrial loan totaling $234,000 at September 30, 2017 that was modified during the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2017 because the borrower was more than 90 days delinquent on their scheduled loan payments. There were no loansLoans that were modified during the previous twelve months that subsequently defaulted during the three and nine months ended September 30, ~~2016.~~2018 and 2017 are set forth in the following table:



	Three Months Ended September 30,
	2018			2017
	Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	2	$	1,742	1	$	234
Total commercial business	2	1,742		1	234
Total	2	$	1,742	1	$	234

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	Nine Months Ended September 30,
	2018			2017
	Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	7	$	2,020	1	$	234
Owner-occupied commercial real estate	1	69		—	—
Non-owner occupied commercial real estate	—	—		—	—
Total commercial business	8	2,089		1	234
Real estate construction and land development:
One-to-four family residential	2	767		—	—
Total real estate construction and land development	2	767		—	—
Total	10	$	2,856	1	$	234

During the nine months ended September 30, 2018, one owner-occupied commercial real estate TDR loan and two commercial and industrial TDR loans with a total outstanding balance of $69,000 and $1.7 million, respectively, defaulted because each was past its modified maturity date, and the borrower has not subsequently repaid the credits. The Bank has chosen not to further extend the maturity date on these loans. In addition, during the nine months ended September 30, 2018, one commercial and industrial TDR loan and two construction TDR loans with total outstanding balances of $279,000 and $767,000, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments. Also, four commercial and industrial TDR loans defaulted and subsequently repaid their credits during nine months ended September 30, 2018. The Bank had a $320,000 specific valuation allowance at September 30, 2018 related to these TDR loans which defaulted during the nine months ended September 30, 2018.

During both the three and nine months ended September 30, 2017, the one commercial and industrial TDR loan defaulted because the borrower was more than 90 days delinquent on his scheduled loan payment.

(h) Purchased Credit Impaired Loans

The Company acquired certain loans and designated them, as appropriate, as PCI loans, which are accounted for under FASB ASC ~~310-30,~~310-30. No loans acquired in the ~~Washington Banking Merger on May 1, 2014~~Premier and ~~in previously completed acquisitions, including the FDIC-assisted acquisitions~~Puget Mergers were considered PCI.

Table of Cowlitz Bank ("Cowlitz") and Pierce Commercial Bank ("Pierce") on July 30, 2010 and November 8, 2010, respectively, and the acquisitions of Northwest Commercial Bank ("NCB") on January 9, 2013 and Valley Community Bancshares, Inc. ("Valley") on July 15, 2013.Contents

The following table reflects the outstanding principal balance and recorded investment of the PCI loans at September 30, ~~2017~~2018 and December 31, ~~2016:~~2017:

September 30, 2017 December 31, 2016
Outstanding Principal Recorded Investment Outstanding Principal Recorded Investment
(In thousands)
Commercial business:
Commercial and industrial $ 9,220
$ 5,001
$ 13,067
$ 9,317
Owner-occupied commercial real estate 14,059
12,492
17,639
15,973
Non-owner occupied commercial real estate 15,026
13,058
25,037
23,360
Total commercial business 38,305
30,551
55,743
48,650
One-to-four family residential 4,426
3,983
5,120
4,905
Real estate construction and land development:
One-to-four family residential 2,928
1,749
2,958
2,123
Five or more family residential and commercial properties 2,392
2,284
2,614
2,488
Total real estate construction and land development 5,320
4,033
5,572
4,611
Consumer 3,998
5,129
5,296
6,282
Gross PCI loans $ 52,049
$ 43,696
$ 71,731
$ 64,448

~~Table of Contents~~



	September 30, 2018				December 31, 2017
	Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment
	(In thousands)
Commercial business:
Commercial and industrial	$	7,182	$	3,758	$	8,818	$	2,912
Owner-occupied commercial real estate	9,277		8,258		12,230		11,515
Non-owner occupied commercial real estate	9,051		8,020		14,295		13,342
Total commercial business	25,510		20,036		35,343		27,769
One-to-four family residential	3,279		3,416		4,120		5,255
Real estate construction and land development:
One-to-four family residential	87		387		841		89
Five or more family residential and commercial properties	1,787		1,268		2,361		2,035
Total real estate construction and land development	1,874		1,655		3,202		2,124
Consumer	2,500		3,746		3,974		5,455
Gross PCI loans	$	33,163	$	28,853	$	46,639	$	40,603

On the acquisition dates, the amount by which the undiscounted expected cash flows of the PCI loans exceeded the estimated fair value of the loan is the “accretable yield.” The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the PCI loans.

The following table summarizes the accretable yield on the PCI loans for the three and nine months ended September 30, ~~2017~~2018 and ~~2016.~~2017.


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016			2018			2017			2018			2017
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	12,296		$	15,359		$	13,860		$	17,592		$	10,060		$	12,296		$	11,224		$	13,860
Accretion	(796		)	(1,178		)	(2,725		)	(3,900		)	(644		)	(796		)	(2,011		)	(2,725		)
Disposal and other	(1,287		)	(491		)	(2,430		)	(2,921		)	(164		)	(1,287		)	(2,136		)	(2,430		)
Change in accretable yield	939			1,214			2,447			4,133			1,198			939			3,373			2,447
Balance at the end of the period	$	11,152		$	14,904		$	11,152		$	14,904		$	10,450		$	11,152		$	10,450		$	11,152

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~~(4)~~(5)	Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable incurred credit losses in the loan portfolio. The following tables detail the activity in the allowance for loan losses disaggregated by segment and class for the three and nine months ended September 30, ~~2017:~~

~~Table of Contents~~

2018:


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended September 30, 2017
Three Months Ended September 30, 2018
Commercial business:
Commercial and industrial	$	10,651	$	(3	)	$	4	$	(772	)	$	9,880	$	10,188	$	(151	)	$	119	$	122		$	10,278
Owner-occupied commercial real estate	4,154		(1,494		)	4		1,397			4,061		5,246		—			2		181			5,429
Non-owner occupied commercial real estate	7,709		—			—		(415		)	7,294		7,726		(149		)	—		71			7,648
Total commercial business	22,514		(1,497		)	8		210			21,235		23,160		(300		)	121		374			23,355
One-to-four family residential	1,073		(15		)	—		(21		)	1,037		1,121		(15		)	—		50			1,156
Real estate construction and land development:
One-to-four family residential	821		(556		)	191		337			793		1,016		—			3		156			1,175
Five or more family residential and commercial properties	1,666		—			—		(271		)	1,395		1,044		—			—		(15		)	1,029
Total real estate construction and land development	2,487		(556		)	191		66			2,188		2,060		—			3		141			2,204
Consumer	5,710		(478		)	112		453			5,797		6,305		(530		)	159		474			6,408
Unallocated	967		—			—		176			1,143		1,326		—			—		26			1,352
Total	$	32,751	$	(2,546	)	$	311	$	884		$	31,400	$	33,972	$	(845	)	$	283	$	1,065		$	34,475

Nine Months Ended September 30, 2017
Nine Months Ended September 30, 2018
Commercial business:
Commercial and industrial	$	10,968	$	(361	)	$	679	$	(1,406	)	$	9,880	$	9,910	$	(773	)	$	683	$	458		$	10,278
Owner-occupied commercial real estate	3,661		(1,579		)	155		1,824			4,061		3,992		(1		)	7		1,431			5,429
Non-owner occupied commercial real estate	7,753		—			—		(459		)	7,294		8,097		(149		)	—		(300		)	7,648
Total commercial business	22,382		(1,940		)	834		(41		)	21,235		21,999		(923		)	690		1,589			23,355
One-to-four family residential	1,015		(15		)	1		36			1,037		1,056		(30		)	—		130			1,156
Real estate construction and land development:
One-to-four family residential	797		(556		)	201		351			793		862		—			5		308			1,175
Five or more family residential and commercial properties	1,359		—			—		36			1,395		1,190		—			—		(161		)	1,029
Total real estate construction and land development	2,156		(556		)	201		387			2,188		2,052		—			5		147			2,204
Consumer	5,024		(1,419		)	329		1,863			5,797		6,081		(1,709		)	389		1,647			6,408
Unallocated	506		—			—		637			1,143		898		—			—		454			1,352
Total	$	31,083	$	(3,930	)	$	1,365	$	2,882		$	31,400	$	32,086	$	(2,662	)	$	1,084	$	3,967		$	34,475

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The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of September 30, ~~2017.~~2018.


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	1,254	$	7,589	$	1,037	$	9,880	$	1,711	$	7,674	$	893	$	10,278
Owner-occupied commercial real estate	767		2,434		860		4,061		1,825		2,871		733		5,429
Non-owner occupied commercial real estate	895		5,389		1,010		7,294		739		6,236		673		7,648
Total commercial business	2,916		15,412		2,907		21,235		4,275		16,781		2,299		23,355
One-to-four family residential	96		740		201		1,037		80		946		130		1,156
Real estate construction and land development:
One-to-four family residential	—		568		225		793		6		947		222		1,175
Five or more family residential and commercial properties	39		1,259		97		1,395		—		950		79		1,029
Total real estate construction and land development	39		1,827		322		2,188		6		1,897		301		2,204
Consumer	60		4,991		746		5,797		113		5,729		566		6,408
Unallocated	—		1,143		—		1,143		—		1,352		—		1,352
Total	$	3,111	$	24,113	$	4,176	$	31,400	$	4,474	$	26,705	$	3,296	$	34,475

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of September 30, ~~2017:~~2018:


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	11,712	$	648,869	$	5,001	$	665,582	$	14,230	$	843,542	$	3,758	$	861,530
Owner-occupied commercial real estate	5,758		583,988		12,492		602,238		12,881		764,277		8,258		785,416
Non-owner occupied commercial real estate	10,783		906,347		13,058		930,188		10,347		1,264,793		8,020		1,283,160
Total commercial business	28,253		2,139,204		30,551		2,198,008		37,458		2,872,612		20,036		2,930,106
One-to-four family residential	304		77,135		3,983		81,422		285		92,632		3,416		96,333
Real estate construction and land development:
One-to-four family residential	1,347		48,355		1,749		51,451		1,076		105,685		387		107,148
Five or more family residential and commercial properties	658		120,039		2,284		122,981		—		119,519		1,268		120,787
Total real estate construction and land development	2,005		168,394		4,033		174,432		1,076		225,204		1,655		227,935
Consumer	434		335,080		5,129		340,643		410		387,127		3,746		391,283
Total	$	30,996	$	2,719,813	$	43,696	$	2,794,505	$	39,229	$	3,577,575	$	28,853	$	3,645,657

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The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three and nine months ended September 30, ~~2016.~~2017.


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended September 30, 2016
Three Months Ended September 30, 2017
Commercial business:
Commercial and industrial	$	9,970	$	(240	)	$	993	$	182		$	10,905	$	10,651	$	(3	)	$	4	$	(772	)	$	9,880
Owner-occupied commercial real estate	3,578		(88		)	—		222			3,712		4,154		(1,494		)	4		1,397			4,061
Non-owner occupied commercial real estate	6,924		—			—		303			7,227		7,709		—			—		(415		)	7,294
Total commercial business	20,472		(328		)	993		707			21,844		22,514		(1,497		)	8		210			21,235
One-to-four family residential	950		—			—		26			976		1,073		(15		)	—		(21		)	1,037
Real estate construction and land development:
One-to-four family residential	754		—			—		96			850		821		(556		)	191		337			793
Five or more family residential and commercial properties	1,277		—			—		5			1,282		1,666		—			—		(271		)	1,395
Total real estate construction and land development	2,031		—			—		101			2,132		2,487		(556		)	191		66			2,188
Consumer	4,816		(572		)	197		665			5,106		5,710		(478		)	112		453			5,797
Unallocated	157		—			—		(4		)	153		967		—			—		176			1,143
Total	$	28,426	$	(900	)	$	1,190	$	1,495		$	30,211	$	32,751	$	(2,546	)	$	311	$	884		$	31,400

Nine Months Ended September 30, 2016
Nine Months Ended September 30, 2017
Commercial business:
Commercial and industrial	$	9,972	$	(2,810	)	$	1,352	$	2,391		$	10,905	$	10,968	$	(361	)	$	679	$	(1,406	)	$	9,880
Owner-occupied commercial real estate	4,370		(538		)	—		(120		)	3,712		3,661		(1,579		)	155		1,824			4,061
Non-owner occupied commercial real estate	7,722		(350		)	—		(145		)	7,227		7,753		—			—		(459		)	7,294
Total commercial business	22,064		(3,698		)	1,352		2,126			21,844		22,382		(1,940		)	834		(41		)	21,235
One-to-four family residential	1,157		—			2		(183		)	976		1,015		(15		)	1		36			1,037
Real estate construction and land development:
One-to-four family residential	1,058		(100		)	83		(191		)	850		797		(556		)	201		351			793
Five or more family residential and commercial properties	813		(54		)	—		523			1,282		1,359		—			—		36			1,395
Total real estate construction and land development	1,871		(154		)	83		332			2,132		2,156		(556		)	201		387			2,188
Consumer	4,309		(1,370		)	496		1,671			5,106		5,024		(1,419		)	329		1,863			5,797
Unallocated	345		—			—		(192		)	153		506		—			—		637			1,143
Total	$	29,746	$	(5,222	)	$	1,933	$	3,754		$	30,211	$	31,083	$	(3,930	)	$	1,365	$	2,882		$	31,400

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The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of December 31, ~~2016.~~2017.


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	1,199	$	8,048	$	1,721	$	10,968	$	1,326	$	7,558	$	1,026	$	9,910
Owner-occupied commercial real estate	511		1,834		1,316		3,661		621		2,557		814		3,992
Non-owner occupied commercial real estate	797		5,142		1,814		7,753		1,222		5,919		956		8,097
Total commercial business	2,507		15,024		4,851		22,382		3,169		16,034		2,796		21,999
One-to-four family residential	97		643		275		1,015		93		798		165		1,056
Real estate construction and land development:
One-to-four family residential	6		538		253		797		2		635		225		862
Five or more family residential and commercial properties	60		1,168		131		1,359		37		1,064		89		1,190
Total real estate construction and land development	66		1,706		384		2,156		39		1,699		314		2,052
Consumer	64		3,912		1,048		5,024		54		5,303		724		6,081
Unallocated	—		506		—		506		—		898		—		898
Total	$	2,734	$	21,791	$	6,558	$	31,083	$	3,355	$	24,732	$	3,999	$	32,086

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, ~~2016:~~2017:


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	12,375	$	616,081	$	9,317	$	637,773	$	11,999	$	630,485	$	2,912	$	645,396
Owner-occupied commercial real estate	4,724		537,338		15,973		558,035		6,808		603,827		11,515		622,150
Non-owner occupied commercial real estate	11,318		846,202		23,360		880,880		16,019		957,233		13,342		986,594
Total commercial business	28,417		1,999,621		48,650		2,076,688		34,826		2,191,545		27,769		2,254,140
One-to-four family residential	321		72,165		4,905		77,391		299		81,443		5,255		86,997
Real estate construction and land development:
One-to-four family residential	3,071		45,220		2,123		50,414		1,247		50,649		89		51,985
Five or more family residential and commercial properties	1,079		105,197		2,488		108,764		645		94,819		2,035		97,499
Total real estate construction and land development	4,150		150,417		4,611		159,178		1,892		145,468		2,124		149,484
Consumer	310		318,548		6,282		325,140		442		349,194		5,455		355,091
Total	$	33,198	$	2,540,751	$	64,448	$	2,638,397	$	37,459	$	2,767,650	$	40,603	$	2,845,712

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~~(5)~~(6)	Other Real Estate Owned

Changes in other real estate owned during the three and nine months ended September 30, ~~2017~~2018 and ~~2016~~2017 were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016			2018			2017			2018			2017
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	786		$	1,560		$	754		$	2,019		$	434		$	786		$	—		$	754
Additions	—			25			32			677			—			—			434			32
Additions from acquisitions													1,796			—			1,796			—
Proceeds from dispositions	(374		)	(1,716		)	(374		)	(2,486		)	(198		)	(374		)	(198		)	(374		)
Gain on sales, net	111			131			111			173			—			111			—			111
Valuation adjustment	—			—			—			(383		)
Balance at the end of the period	$	523		$	—		$	523		$	—		$	2,032		$	523		$	2,032		$	523

At September 30, ~~2017,~~2018, the carrying amount of other real estate owned that was the result of foreclosure and obtaining physical possession of residential real estate properties was ~~$523,000.~~$434,000. At September 30, ~~2017,~~2018, the recorded investment of consumer mortgage loans secured by residential real estate properties (included in the one-to-four family residential ~~loan class~~loans in Note ~~(3)~~(4) Loans Receivable) for which formal foreclosure proceedings were in process was ~~$657,000.~~$258,000.


~~(6)~~(7)	Goodwill and Other Intangible Assets

(a) Goodwill

The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the recent Premier Merger on July 2, 2018 and Puget Sound Merger on January 16, 2018 and the historical acquisitions of Washington Banking ~~Merger~~Company on May 1, ~~2014, and the acquisitions of~~2014; Valley Community Bancshares on July 15, ~~2013,~~2013; Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).

~~There were no additions to~~The following table presents the change in goodwill for the periods indicated:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
	(In thousands)
Balance at the beginning of the period	$	187,549	$	119,029	$	119,029	$	119,029
Additions as a result of acquisitions⁽¹⁾	53,288		—		121,808		—
Balance at the end of the period	$	240,837	$	119,029	$	240,837	$	119,029

⁽¹⁾ See Note (2) Business Combinations

The Company performed its annual goodwill impairment test during the ~~three and nine months ended September 30,~~fourth quarter of 2017 and ~~2016.~~

~~At September 30, 2017, the Company’s step-one~~determined based on its Step 1 analysis ~~concluded~~ that the ~~reporting unit’s~~ fair value ~~was greater than its~~of the reporting unit exceeded the carrying value, ~~and therefore no~~such that the Company's goodwill ~~impairment charges were required,~~was not considered impaired. Changes in the economic environment, operations of the reporting unit or recorded, for the three and nine months ended September 30, 2017. Similarly, no goodwill impairment charges were required, or recorded, for the three and nine months ended September 30, 2016. Even though there was no goodwill impairment at ~~September 30, 2017~~,other adverse events ~~may impact the recoverability of goodwill and~~ could result in a future impairment ~~charge~~charges which could have a material impact on the Company’s operating results.

(b) Other Intangible Assets

The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI related to the acquisitions of Premier Commercial Bancorp, Puget Sound Bancorp, Washington Banking ~~Merger, the acquisitions of~~Company, Valley ~~NCB~~Community Bancshares, and ~~Cowlitz~~Northwest Commercial Bank were estimated to be ten, ten, ~~five~~ten, ten, and ~~nine~~five years, respectively.

~~The following table presents the change in the other intangible assets for the periods indicated:~~

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(In thousands)
Balance at the beginning of the period $ 6,727
$ 8,091
$ 7,374
$ 8,789
Less: Amortization 319
359
966
1,057
Balance at the end of the period $ 6,408
$ 7,732
$ 6,408
$ 7,732


~~(7)~~	~~Other Borrowings~~

~~(a) Federal Home Loan Bank Advances~~

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has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At September 30, 2017, the Bank maintained a credit facility with the FHLB of Des Moines for $662.4 million and had short-term FHLB advances outstanding of $117.4 million with maturity dates within 30 days. At December 31, 2016 there were FHLB advances outstanding of $79.6 million.

The following table ~~sets forth~~presents the ~~details of FHLB advances during~~change in other intangible assets for the ~~three and nine months ended September 30, 2017 and 2016:~~periods indicated:

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands)
Average balance during the period $ 111,293
$ 5,618
$ 106,553
$ 11,608
Maximum month-end balance during the period $ 126,200
$ 17,700
$ 137,450
$ 57,300
Weighted average rate during the period 1.53 % 0.57 % 1.09 % 0.54 %



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
	(In thousands)
Balance at the beginning of the period	$	15,767		$	6,727		$	6,088		$	7,374
Additions as a result of acquisitions ⁽¹⁾	7,075			—			18,345			—
Amortization	(1,114		)	(319		)	(2,705		)	(966		)
Balance at the end of the period	$	21,728		$	6,408		$	21,728		$	6,408

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, principally investment securities which are obligations of or guaranteed by the United States or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

~~(b) Federal Funds Purchased~~

The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of September 30, 2017. The lines generally mature annually or are reviewed annually. As of September 30, 2017 and December 31, 2016, there were no federal funds purchased.

~~(c) Credit facilities~~

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $50.6 million as of September 30, 2017, of which there were no borrowings outstanding as of September 30, 2017 or December 31, 2016. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.⁽¹⁾ See Note (2) Business Combinations


(8)	Junior Subordinated Debentures

As part of the acquisition of Washington Banking ~~Merger,~~Company on May 1, 2014, the Company assumed trust preferred securities and junior subordinated debentures with a total fair value of $18.9 million at the ~~May 1, 2014~~ merger date.

Washington Banking Master Trust, a Delaware statutory business trust, was a wholly-owned subsidiary of the Washington Banking Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated ~~debt~~debentures issued by the Washington ~~Banking.~~Banking Company. During 2007, the Trust issued $25.0 million of trust preferred securities with a 30-year maturity, callable after the fifth year by the Washington Banking. The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank Offered Rate (“LIBOR”) plus 1.56%. On the ~~Washington Banking Merger~~merger date, ~~of May 1, 2014,~~ the Company acquired the Trust, which retained the Washington Banking Master Trust name, and assumed the performance and observance of the covenants under the indenture related to the trust preferred securities.

The adjustable rate of the trust preferred securities at September 30, ~~2017~~2018 was ~~2.89%~~3.96%. The weighted average rate of the junior subordinated debentures was ~~5.20% and 5.05%~~as follows for the ~~three and nine months ended September 30, 2017, respectively, and 4.49% and 4.43% for the three and nine months ended September 30, 2016, respectively.~~ indicated periods:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Weighted average rate ⁽¹⁾	6.49	%	5.20	%	6.17	%	5.05	%

⁽¹⁾The weighted average rate includes the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.

The junior subordinated debentures are the sole assets of the Trust and payments under the junior subordinated debentures are the sole revenues of the Trust. At September 30, ~~2017~~2018 and December 31, ~~2016,~~2017, the balance of the junior subordinated debentures, net of unaccreted discount, was ~~$19.9~~$20.2 million and ~~$19.7~~$20.0 million, respectively. All of the common securities of the Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method and is included in prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition. The junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities on the Company's Condensed Consolidated Statements of Financial Condition.

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(9)	Repurchase Agreements

The Company utilizes repurchase agreements with one-day maturities as a supplement to funding sources. Repurchase agreements are secured by pledged investment securities available for sale. Under the repurchase agreements, the Company is required to maintain an aggregate market value of securities pledged greater than the balance of the repurchase agreements. The Company is required to pledge additional securities to cover any declines below the balance of the repurchase agreements. For additional information on the total value of investment securities pledged for repurchase agreements see Note ~~(2)~~(3) Investment Securities.

The following table presents the Company's repurchase agreement obligations by class of collateral pledged:


	September 30, 2017		December 31, 2016		September 30, 2018		December 31, 2017
	(In thousands)				(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	—	$	2,944	$	4,890	$	—
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	12,336		5,191		9,971		11,239
Commercial	16,332		13,969		17,372		20,582
Total repurchase agreements	$	28,668	$	22,104	$	32,233	$	31,821

⁽¹⁾ Issued and guaranteed by U.S. Government-sponsored agencies.


(10)	Other Borrowings

(a) FHLB

The Federal Home Loan Bank ("FHLB") of Des Moines functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At September 30, 2018, the Bank maintained a credit facility with the FHLB of Des Moines with available borrowing capacity of $826.8 million. The Bank had no FHLB advances outstanding at September 30, 2018. At December 31, 2017 there were FHLB advances outstanding of $92.5 million.

The following table sets forth the details of FHLB advances during the three and nine months ended September 30, 2018 and 2017:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
	(In thousands)
FHLB Advances:
Average balance during the period	$	20,892		$	111,293		$	45,193		$	106,553
Maximum month-end balance during the period	$	50,500		$	126,200		$	154,500		$	137,450
Weighted average rate during the period	2.22		%	1.53		%	1.98		%	1.09		%

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, investment securities which are obligations of or guaranteed by the United States, or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

(b) Federal Funds Purchased

The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank ("TIB") and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of September 30, 2018. The lines generally mature annually or are reviewed annually. As of September 30, 2018 and December 31, 2017, there were no federal funds purchased.

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco ("Federal Reserve Bank") with available borrowing capacity of $45.2 million as of September 30, 2018. There were no borrowings outstanding

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as of September 30, 2018 or December 31, 2017. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.


(11)	Derivative Financial Instruments

The Company has entered into certain interest rate swap contracts that are not designated as hedging instruments. The purpose of these derivative contracts is primarily to provide commercial business loan customers the ability to convert their loans from variable to fixed interest rates. Upon the origination of a derivative contract with a customer, the Company simultaneously enters into an offsetting derivative contract with a third party in order to offset its exposure on the variable and fixed rate components of the customer agreement. The Company recognizes immediate income based upon the difference in the bid/ask spread of the underlying transactions with its customers and the third party, which is recorded in interest rate swap fees on the Condensed Consolidated Statements of Income. Because the Company acts only as an intermediary for its customer, subsequent changes in the fair value of the underlying derivative contracts offset each other and do not significantly impact the Company’s results of operations.

The notional amounts and estimated fair values of interest rate derivative contracts outstanding at September 30, ~~2017~~2018 and December 31, ~~2016~~2017 are presented in the following table.


	September 30, 2017					December 31, 2016					September 30, 2018					December 31, 2017
	Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value
	(In thousands)										(In thousands)
Non-hedging interest rate derivatives
Interest rate swaps with customer ⁽¹⁾	$	134,295	$	74		$	102,709	$	(1,099	)	$	162,275	$	(7,050	)	$	146,537	$	(882	)
Interest rate swap with third party ⁽¹⁾	134,295		(74		)	102,709		1,099			162,275		7,050			146,537		882

⁽¹⁾The estimated fair value of the derivative included in prepaid and other assets on the Condensed Consolidated Statements of Financial Condition was ~~$3.3~~$7.7 million and ~~$2.8~~$3.4 million as of September 30, ~~2017~~2018 and December 31, ~~2016,~~2017, respectively. The estimated fair value of the derivative included in accrued expenses and other liabilities on the Condensed Consolidated Statements of Financial Condition was ~~$3.3~~$7.7 million and ~~$2.8~~$3.4 million as of September 30, ~~2017~~2018 and December 31, ~~2016,~~2017, respectively.

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~~(11)~~(12)	Stockholders’ Equity

(a) Earnings Per Common Share

The following table illustrates the reconciliation of weighted average shares used for earnings per common share computations for the three and nine months ended September 30, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016			2018			2017			2018			2017
	(Dollars in thousands)												(Dollars in thousands)
Net income:
Net income	$	10,624		$	11,039		$	31,768		$	29,025		$	15,504		$	10,624		$	36,448		$	31,768
Less: Dividends and undistributed earnings allocated to participating securities	(64		)	(102		)	(228		)	(280		)	(48		)	(64		)	(252		)	(228		)
Net income allocated to common shareholders	$	10,560		$	10,937		$	31,540		$	28,745		$	15,456		$	10,560		$	36,196		$	31,540
Basic:
Weighted average common shares outstanding	29,929,721			29,962,270			29,940,276			29,968,034			36,839,615			29,929,721			34,744,788			29,940,276
Less: Restricted stock awards	(146,425		)	(277,495		)	(192,186		)	(292,832		)	(67,669		)	(146,425		)	(94,340		)	(192,186		)
Total basic weighted average common shares outstanding	29,783,296			29,684,775			29,748,090			29,675,202			36,771,946			29,783,296			34,650,448			29,748,090
Diluted:
Basic weighted average common shares outstanding	29,783,296			29,684,775			29,748,090			29,675,202			36,771,946			29,783,296			34,650,448			29,748,090
Effect of potentially dilutive common shares ⁽¹⁾	107,414			11,031			86,004			12,543			191,298			107,414			170,154			86,004
Total diluted weighted average common shares outstanding	29,890,710			29,695,806			29,834,094			29,687,745			36,963,244			29,890,710			34,820,602			29,834,094


⁽¹⁾	Represents the effect of the assumed exercise of stock options and vesting of restricted stock units.

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. Anti-dilution occurs when the exercise price of a stock option or the unrecognized compensation cost per share of a restricted stock award exceeds the market price of the Company’s stock. For the three and nine months ended September 30, ~~2017~~2018 and ~~the three months ended September 30, 2016,~~2017, there were no anti-dilutive shares outstanding related to options to acquire common stock. For the nine months ended September 30, 2016, anti-dilutive shares outstanding related to options to acquire common stock totaled 580 as the assumed proceeds from exercise price, tax benefits and future compensation were in excess of the market value.

(b) Dividends

The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.

The following table summarizes the dividend activity for the nine months ended September 30, ~~2017~~2018 and calendar year ~~2016.~~2017.



Declared	Cash Dividend per Share	Record Date	Paid Date
~~January 27, 2016~~	~~$0.11~~	~~February 10, 2016~~	~~February 24, 2016~~
~~April 20, 2016~~	~~$0.12~~	~~May 5, 2016~~	~~May 19, 2016~~
~~July 20, 2016~~	~~$0.12~~	~~August 4, 2016~~	~~August 18, 2016~~
~~October 26, 2016~~	~~$0.12~~	~~November 8, 2016~~	~~November 22, 2016~~
~~October 26, 2016~~	~~$0.25~~	~~November 8, 2016~~	~~November 22, 2016~~	*
January 25, 2017	$0.12	February 9, 2017	February 23, 2017
April 25, 2017	$0.13	May 10, 2017	May 24, 2017
July 25, 2017	$0.13	August 10, 2017	August 24, 2017
October 25, 2017	$0.13	November 8, 2017	November 22, 2017
October 25, 2017	$0.10	November 8, 2017	November 22, 2017	*
January 24, 2018	$0.15	February 7, 2018	February 21, 2018
April 25, 2018	$0.15	May 10, 2018	May 24, 2018
July 24, 2018	$0.15	August 9, 2018	August 23, 2018

* Denotes a special dividend.

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The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal ~~Reserve Board"~~Reserve") provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve ~~Board~~ and the FDIC.

The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.

~~The following table provides total~~Since the inception of the eleventh plan, the Company has repurchased 579,996 shares ~~and~~at an average share prices of $16.67. No shares were repurchased under ~~the~~this plan ~~for the periods indicated:~~

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
Plan Total⁽¹⁾
Eleventh Plan
Repurchased shares —
38,000
—
138,000
579,996
Stock repurchase average share price $ —
$ 17.46
$ —
$ 17.16
$ 16.76

~~(1) Represents shares repurchased and average price per share paid~~ during the ~~duration of the plan.~~three and nine months ended September 30, 2018 and 2017.

In addition to the stock repurchases ~~disclosed in the table above,~~under a plan, the Company ~~repurchased~~repurchases shares to pay withholding taxes on the vesting of restricted ~~stock.~~ stock awards and units. The following table provides total repurchased shares for the periods indicated:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	368		344		53,188		27,711
Stock repurchase to pay withholding taxes average share price	$	36.34	$	25.80	$	31.99	$	24.61

⁽¹⁾During the ~~three and~~ nine months ended September 30, ~~2017,~~2018, the Company repurchased ~~344~~26,741 shares related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock shares with an average share price of $31.80 under the terms of the merger. See Note (2) Business Combinations. There were no shares repurchased as a result of the accelerated vesting of the restricted stock awards of Premier.

(d) Issuance of Common Stock

In conjunction with the Premier Merger effective on July 2, 2018 and ~~27,711~~the Puget Sound Merger effective on January 16, 2018, Heritage issued 2,848,579 and 4,112,258 shares, respectively, of the Company's common stock at ~~an average~~the merger date share price ~~per share~~ of ~~$25.80~~$34.85 and ~~$24.61 to pay withholding taxes on the vesting~~$31.80, respectively, for a fair value of ~~restricted stock that vested during the respective periods. During the three~~$99.3 million and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.$130.8 million, respectively.

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~~(12)~~(13)	Accumulated Other Comprehensive (Loss) Income

The changes in accumulated other comprehensive (loss) income ~~(loss)~~ (“AOCI”) ~~by component, during the three and nine months ended September 30, 2017 and 2016 are as follows:~~

Three Months Ended September 30, 2017 ⁽¹⁾

Nine Months Ended September 30, 2017 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ 1,557
$ (2,606 )
Other comprehensive income before reclassification 289
4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income (28 ) (104 )
Net current period other comprehensive income 261
4,424
Balance of AOCI at the end of period $ 1,818
$ 1,818

~~(1) All amounts~~, all of which are due to ~~the~~ changes in the fair value of available for sale securities and are net of ~~tax.~~

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tax for the periods provided.

Three Months Ended
September 30, 2016 ⁽¹⁾

Nine Months Ended September 30, 2016 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ 12,343
$ 2,559
Other comprehensive income before reclassification (1,055 ) 9,223
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income (224 ) (718 )
Net current period other comprehensive income (1,279 ) 8,505
Balance of AOCI at the end of period $ 11,064
$ 11,064

~~(1) All amounts are due to the changes in fair value of available for sale securities and are net of tax.~~



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
	(In thousands)
Balance of AOCI at the beginning of period	$	(11,306	)	$	1,557		$	(1,298	)	$	(2,606	)
Other comprehensive (loss) income before reclassification	(3,319		)	289			(13,193		)	4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(65		)	(28		)	(106		)	(104		)
Net current period other comprehensive (loss) income	(3,384		)	261			(13,299		)	4,424
ASU 2016-01 implementation	—			—			(93		)	—
Balance of AOCI at the end of period	$	(14,690	)	$	1,818		$	(14,690	)	$	1,818


~~(13)~~	~~Stock-Based Compensation~~

Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. Restricted stock awards issued generally have a four-year cliff vesting or four-year ratable vesting schedule. Restricted stock units vest ratably over three years. Performance restricted stock units issued generally have a three-year cliff vesting schedule. Additionally, performance restricted stock unit grants may be subject to performance-based vesting as well as other approved vesting conditions. The Company issues new shares of common stock to satisfy share option exercises, restricted stock awards and restricted stock units.

~~Under the Company's stock-based compensation plans, 1,073,146 shares remain available for future issuance as of September 30, 2017.~~

~~(a) Stock Option Awards~~

For the three and nine months ended September 30, 2017 and 2016, the Company did not recognize any compensation expense or related tax benefit related to stock options as all of the compensation expense related to the outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the nine months ended September 30, 2017 was $156,000 and $159,000, respectively. The intrinsic value and cash proceeds from options exercised during the nine months ended September 30, 2016 was ~~$99,000~~ ~~and~~ ~~$401,000, respectively.~~

~~The following table summarizes the stock option activity for the nine months ended September 30, 2017 and 2016:~~

Shares Weighted-Average Exercise Price
Weighted-Average
Remaining
Contractual
Term (In years)

Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 2015 79,408
$ 14.19

Exercised (27,867 ) 14.37

Forfeited or expired (4,200 ) 16.80

Outstanding at September 30, 2016 47,341
$ 13.85
2.80 $ 194

Outstanding at December 31, 2016 37,495
$ 13.77

Exercised (12,304 ) 12.92

Forfeited or expired (1,308 ) 13.53

Outstanding, vested and expected to vest and exercisable at September 30, 2017 23,883
$ 14.23
2.45 $ 365

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~~(b) Restricted Stock Awards~~

For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock awards of $292,000 and $1.1 million, respectively, and a related tax benefit of $102,000 and $384,000, respectively. For the three and nine months ended September 30, 2016, the Company recognized compensation expense related to restricted stock awards of $494,000 and $1.4 million, respectively, and a related tax benefit of $173,000 and $479,000, respectively. As of ~~September 30, 2017~~, the total unrecognized compensation expense related to non-vested restricted stock awards was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.78 years. The vesting date fair value of the restricted stock awards that vested during the nine months ended September 30, 2017 and 2016 was $2.7 million and $2.0 million, respectively.

~~The following table summarizes the restricted stock award activity for the nine months ended September 30, 2017 and 2016:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015 264,521
$ 15.92
Granted 119,939
17.53
Vested (111,357 ) 15.62
Forfeited (9,216 ) 16.57
Nonvested at September 30, 2016 263,887
$ 16.76

Nonvested at December 31, 2016 261,296
$ 16.80
Granted —
—
Vested (107,202 ) 16.49
Forfeited (10,418 ) 16.80
Nonvested at September 30, 2017 143,676
$ 17.02

~~(c) Restricted Stock Units~~

For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock units of $236,000 and $472,000, respectively, and a related tax benefit of $83,000 and $165,000, respectively. As of September 30, 2017, the total unrecognized compensation expense related to non-vested restricted stock units was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.26 years.

~~The following table summarizes the restricted stock unit activity for the nine months ended September 30, 2017:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016 —
$ —
Granted 92,019
25.29
Vested —
—
Forfeited (1,812 ) 25.35
Nonvested at September 30, 2017 90,207
$ 25.29

~~The following table summarizes the assumptions used in the Monte Carlo model for restricted stock unit grants with market-based conditions during the nine months ended September 30, 2017:~~

Shares Expected Term in Years Weighted-Average Risk Free Interest Rate Expected Volatility Expected Dividend Yield Weighted-Average Fair Value
6,089 2.85 1.40 % 21.8 % — % $ 24.39

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(14)	Fair Value Measurements

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1: Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that allow the Company to sell its ownership interest back to the fund at net asset value on a daily basis. Valuations are obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.

Level 2: Valuations for assets and liabilities traded in less active dealer or broker markets, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or valuations using methodologies with observable inputs.

Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

(a) Recurring and Nonrecurring Basis

The Company used the following methods and significant assumptions to measure the fair value of certain assets on a recurring and nonrecurring basis:

Investment Securities Available for Sale:

The fair values of all investment securities are based upon the assumptions that market participants would use in pricing the security. If available, fair values of investment securities are determined by quoted market prices (Level 1). For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar securities (Level 2). For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.

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Impaired Loans:

At the time a loan is considered impaired, its impairment is measured based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price, or the fair market value of the collateral (less costs to sell) if the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach are not considered to be measured at fair value because the loan’s effective interest rate is generally not a fair value input, and for the purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans. If the Company utilizes the fair market value of the collateral method, the fair value used to measure impairment is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value based on the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business (Level 3). Impaired loans are evaluated on a quarterly basis ~~for additional~~and impairment and is adjusted accordingly.

Other Real Estate Owned:

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less ~~estimated~~ costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose

~~Table of Contents~~

qualifications and licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

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Derivative Financial Instruments:

The Company obtains broker or dealer quotes to value its interest rate derivative contracts, which use valuation models using observable market data as of the measurement date (Level 2).

The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, ~~2017~~2018 and December 31, ~~2016~~2017.


	September 30, 2017								September 30, 2018
	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
	(In thousands)								(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	9,403	$	—	$	9,403	$	—	$	83,798	$	15,879	$	67,919	$	—
Municipal securities	252,806		—		252,806		—		164,072		—		164,072		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	274,361		—		274,361		—		311,916		—		311,916		—
Commercial	213,283		—		213,283		—		309,114		—		309,114		—
Collateralized loan obligations	6,022		—		6,022		—		967		—		967		—
Corporate obligations	15,830		—		15,830		—		25,709		—		25,709		—
Other securities	28,355		150		28,205		—
Other asset-backed securities									25,161		—		25,161		—
Total investment securities available for sale	800,060		150		799,910		—		920,737		15,879		904,858		—
Derivative assets - interest rate swaps	3,308		—		3,308		—		7,659		—		7,659		—
Liabilities
Derivative liabilities - interest rate swaps	$	3,308	$	—	$	3,308	$	—	$	7,659	$	—	$	7,659	$	—

December 31, 2016
Total Level 1 Level 2 Level 3
(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies $ 1,569
$ —
$ 1,569
$ —
Municipal securities 237,256
—
237,256
—
Mortgage-backed securities and collateralized mortgage obligations:
Residential 309,176
—
309,176
—
Commercial 208,318
—
208,318
—
Collateralized loan obligations 10,478
—
10,478
—
Corporate obligations 16,706
—
16,706
—
Other securities 11,142
123
11,019
—
Total investment securities available for sale 794,645
123
794,522
—
Derivative assets - interest rate swaps 2,804
—
2,804
—
Liabilities
Derivative liabilities - interest rate swaps $ 2,804
$ —
$ 2,804
$ —

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	December 31, 2017
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	13,442	$	—	$	13,442	$	—
Municipal securities	250,015		—		250,015		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	280,211		—		280,211		—
Commercial	217,079		—		217,079		—
Collateralized loan obligations	4,580		—		4,580		—
Corporate obligations	16,770		—		16,770		—
Other securities	28,433		146		28,287		—
Total investment securities available for sale	810,530		146		810,384		—
Derivative assets - interest rate swaps	3,418		—		3,418		—
Liabilities
Derivative liabilities - interest rate swaps	$	3,418	$	—	$	3,418	$	—

There were no transfers between Level 1 and Level 2 during the three and nine months ended September 30, ~~2017~~2018 and ~~2016.~~2017.

The Company may be required to measure certain financial assets and liabilities at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

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The tables below represent assets measured at fair value on a nonrecurring basis at September 30, ~~2017~~2018 and December 31, ~~2016~~2017 and the net losses ~~(gains)~~ recorded in earnings during three and nine months ended September 30, ~~2017~~2018 and ~~2016.~~2017.


	Basis⁽¹⁾		Fair Value at September 30, 2017												Basis⁽¹⁾		Fair Value at September 30, 2018
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses Recorded in Earnings During the Three Months Ended September 30, 2017		Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2017		Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended September 30, 2018		Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2018
	(In thousands)														(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	172	$	163	$	—	$	—	$	163	$	—	$	7	$	224	$	187	$	—	$	—	$	187	$	36	$	36
Owner-occupied commercial real estate	182		179		—		—		179		—		8
Total commercial business	354		342		—		—		342		—		15
Real estate construction and land development:
One-to-four family residential															976		303		—		—		303		1		4
Total assets measured at fair value on a nonrecurring basis	$	354	$	342	$	—	$	—	$	342	$	—	$	15	$	1,200	$	490	$	—	$	—	$	490	$	37	$	40


⁽¹⁾	Basis represents the unpaid principal balance of impaired loans.

Basis⁽¹⁾
Fair Value at December 31, 2016
Total Level 1 Level 2 Level 3
Net Losses
(Gains)
Recorded in
Earnings
During
the Three Months Ended September 30, 2016

Net Losses
(Gains)
Recorded in
Earnings
During
the Nine Months Ended September 30, 2016
(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial $ 205
$ 200
$ —
$ —
$ 200
$ 24
$ 25
Owner-occupied commercial real estate 780
603
—
—
603
23
(2 )
Total commercial business 985
803
—
—
803
47
23
Real estate construction and land development:
One-to-four family residential 828
822
—
—
822
(13 ) (26 )
Total real estate construction and land development 828
822
—
—
822
(13 ) (26 )
Consumer 16
9
—
—
9
—
—
Total assets measured at fair value on a nonrecurring basis $ 1,829
$ 1,634
$ —
$ —
$ 1,634
$ 34
$ (3 )



	Basis⁽¹⁾		Fair Value at December 31, 2017
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses Recorded in Earnings During the Three Months Ended September 30, 2017		Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2017
	(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—	$	—
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—	$	—


⁽¹⁾	Basis represents the unpaid principal balance of impaired loans.

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The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, ~~2017~~2018 and December 31, ~~2016~~2017.

September 30, 2017

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 342
Market approach Adjustment for differences between the comparable sales (23.8%) - 23.0%; (2.8%)



	September 30, 2018
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	490	Market approach	Adjustment for differences between the comparable sales	(91.2%) - (14.4)%; (25.5%)

December 31, 2016

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 1,634
Market approach Adjustment for differences between the comparable sales (23.8%) - 63.9%; 20.4%



	December 31, 2017
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	307	Market approach	Adjustment for differences between the comparable sales	(91.5%) - (14.4%); (44.0%)

(b) Fair Value of Financial Instruments

Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.

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The tables below present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated.


	September 30, 2017										September 30, 2018
	Carrying Value		Fair Value		Fair Value Measurements Using:						Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3						Level 1		Level 2		Level 3
	(In thousands)										(In thousands)
Financial Assets:
Cash and cash equivalents	$	111,258	$	111,258	$	111,258	$	—	$	—	$	170,143	$	170,143	$	170,143	$	—	$	—
Investment securities available for sale	800,060		800,060		150		799,910		—		920,737		920,737		15,879		904,858		—
Federal Home Loan Bank stock	9,343		N/A		N/A		N/A		N/A		6,076		N/A		N/A		N/A		N/A
Loans held for sale	5,368		5,553		—		5,553		—		1,882		1,937		—		1,937		—
Total loans receivable, net	2,766,113		2,772,338		—		—		2,772,338		3,614,579		3,604,468		—		—		3,604,468
Accrued interest receivable	12,295		12,295		3		3,770		8,522		15,735		15,735		13		3,992		11,730
Derivative assets - interest rate swaps	3,308		3,308		—		3,308		—		7,659		7,659		—		7,659		—
Equity security											132		132		132		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	2,925,637		2,925,637		2,925,637		—		—		$	3,894,524	$	3,894,524	$	3,894,524	$	—	$	—
Certificate of deposit accounts	395,181		394,164		—		394,164		—		503,603		506,405		—		506,405		—
Federal Home Loan Bank advances	117,400		117,400		—		117,400		—
Securities sold under agreement to repurchase	28,668		28,668		28,668		—		—		32,233		32,233		32,233		—		—
Junior subordinated debentures	19,936		15,250		—		—		15,250		20,229		20,000		—		—		20,000
Accrued interest payable	148		148		42		73		33		263		263		64		160		39
Derivative liabilities - interest rate swaps	3,308		3,308		—		3,308		—		7,659		7,659		—		7,659		—

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	December 31, 2016										December 31, 2017
	Carrying Value		Fair Value		Fair Value Measurements Using:						Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3						Level 1		Level 2		Level 3
	(In thousands)										(In thousands)
Financial Assets:
Cash and cash equivalents	$	103,745	$	103,745	$	103,745	$	—	$	—	$	103,015	$	103,015	$	103,015	$	—	$	—
Investment securities available for sale	794,645		794,645		123		794,522		—		810,530		810,530		146		810,384		—
Federal Home Loan Bank stock	7,564		N/A		N/A		N/A		N/A		8,347		N/A		N/A		N/A		N/A
Loans held for sale	11,662		11,988		—		11,988		—		2,288		2,364		—		2,364		—
Loans receivable, net of allowance for loan losses	2,609,666		2,675,811		—		—		2,675,811		2,816,985		2,810,401		—		—		2,810,401
Accrued interest receivable	10,925		10,925		3		3,472		7,450		12,244		12,244		23		3,772		8,449
Derivative assets - interest rate swaps	2,804		2,804		—		2,804		—		3,418		3,418		—		3,418		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	$	2,872,247	$	2,872,247	$	2,872,247	$	—	$	—	$	2,994,662	$	2,994,662	$	2,994,662	$	—	$	—
Certificate of deposit accounts	357,401		357,536		—		357,536		—		398,398		397,039		—		397,039		—
Federal Home Loan Bank advances	79,600		79,600		—		79,600		—		92,500		92,500		—		92,500		—
Securities sold under agreement to repurchase	22,104		22,104		22,104		—		—		31,821		31,821		31,821		—		—
Junior subordinated debentures	19,717		15,000		—		—		15,000		20,009		18,500		—		—		18,500
Accrued interest payable	215		215		44		142		29		162		162		45		79		38
Derivative liabilities - interest rate swaps	2,804		2,804		—		2,804		—		3,418		3,418		—		3,418		—


(15)	Stock-Based Compensation

On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan (the "Plan") that provides for the issuance of 1,500,000 shares of the Company's common stock in the form of stock options, stock appreciation rights, stock awards (which includes restricted stock units, restricted stock awards, performance units, performance shares or bonus shares) and cash incentive awards. The ~~methods~~Company issues new shares of common stock to satisfy share option exercises and ~~assumptions, not previously presented, used to estimate fair value are described as follows:~~restricted stock awards. As of September 30, 2018, 955,539 shares remain for future issuance under the Plan.

~~Cash and Cash Equivalents:~~

~~The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).~~(a) Stock Option Awards

~~Federal Home Loan Bank~~ Stock:

~~FHLB~~ options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. For the three and nine months ended September 30, 2018 and 2017, the Company did not recognize any compensation expense or related tax benefit related to stock ~~is not publicly traded; thus, it is not practicable to determine~~options as all of the ~~fair value of FHLB stock due to restrictions placed on its transferability.~~

~~Loans Held for Sale~~:

~~The fair value of loans held for sale is estimated based upon binding contracts or quotes from third party investors for similar loans. (Level 2).~~

~~Loans Receivable~~:

~~Except for certain impaired loans discussed previously, fair value is based on discounted cash flows using current market rates applied~~compensation expense related to the ~~estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on~~outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the ~~exit price concept of~~nine months ended September 30, 2018 was $184,000 and $118,000, respectively. The intrinsic value and cash proceeds from options exercised during the ~~fair value required under FASB ASC 820-10,~~nine months ended September 30, 2017 was ~~Fair Value Measurements~~$156,000 and ~~Disclosures~~$159,000, ~~and generally produce a higher value.~~respectively.

~~Accrued Interest Receivable/Payable~~:

The fair value of accrued interest receivable/payable balances approximates the carrying value. The fair value measurements are commensurate with the asset or liability from which the accrued interest is generated (Level 1, Level 2 and Level 3).

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~~Deposits~~:The following table summarizes the stock option activity for the nine months ended September 30, 2018 and 2017:



	Shares		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Term (In years)	Aggregate Intrinsic Value (In thousands)
Outstanding at December 31, 2016	37,495		$	13.77
Exercised	(12,304	)	12.92
Forfeited or expired	(1,308	)	13.53
Outstanding, vested and expected to vest and exercisable at September 30, 2017	23,883		$	14.23	2.45	$	365

Outstanding at December 31, 2017	23,231		$	14.21
Exercised	(8,842	)	13.30
Forfeited or expired	(831	)	14.77
Outstanding, vested and expected to vest and exercisable at September 30, 2018	13,558		$	14.77	1.64	$	276

(b) Restricted Stock Awards

Restricted stock awards granted generally have a four-year cliff vesting or four-year ratable vesting schedule. For ~~deposits with no contractual maturity,~~ the three and nine months ended September 30, 2018, the Company recognized compensation expense related to restricted stock awards of $186,000 and $718,000, respectively, and a related tax benefit of $39,000 and $151,000, respectively. For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock awards of $292,000 and $1.1 million, respectively, and a related tax benefit of $102,000 and $384,000, respectively. As of September 30, 2018, the total unrecognized compensation expense related to non-vested restricted stock awards was $745,000 and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.15 years. The vesting date fair value of the restricted stock awards that vested during the nine months ended September 30, 2018 and 2017 was $2.2 million and $2.7 million, respectively.

The following table summarizes the restricted stock award activity for the nine months ended September 30, 2018 and 2017:



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	261,296		$	16.80
Vested	(107,202	)	16.49
Forfeited	(10,418	)	16.80
Nonvested at September 30, 2017	143,676		$	17.02

Nonvested at December 31, 2017	137,399		$	17.00
Vested	(67,602	)	16.70
Forfeited	(3,489	)	16.92
Nonvested at September 30, 2018	66,308		$	17.31

During 2017, the Company began issuing stock-settled restricted stock unit awards ("RSU") and performance-based stock-settled restricted stock unit awards ("PRSU"), collectively called "units". RSUs granted vest ratably over three years. PRSUs granted generally have a three-year cliff vesting schedule. Additionally, PRSU grants may be subject to performance-based vesting as well as other approved vesting conditions. The number of shares of actually delivered pursuant to the PRSUs depends on the performance of the Company's Total Shareholder Return and Return on Average Assets over the performance period in relation to the performance of the common stock of a predetermined

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peer group. The conditions of the grants allow for an actual payout ranging between no payout and 150% of target. The payout level is ~~assumed~~calculated based on actual performance achieved during the performance period compared to ~~equal the carrying value (Level 1).~~a defined peer group. The fair value of ~~certificate~~such PRSUs was determined using a Monte Carlo simulation and will be recognized over the subsequent three years. The Monte-Carlo simulation model uses the same input assumptions as the Black-Scholes model; however, it also further incorporates into the fair value determination the possibility that the market condition may not be satisfied. Compensation costs related to these awards are recognized regardless of ~~deposit accounts~~whether the market condition is satisfied, provided that the requisite service has been provided.

Expected volatilities in the model were estimated using a historical period consistent with the performance period of approximately three years. The risk-free interest rate was based on ~~discounted cash flows using~~ the ~~difference between~~United States Treasury rate for a term commensurate with the ~~deposit rate and~~expected life of the ~~rates offered by~~grant. The Company used the ~~Company for deposits of similar remaining maturities (Level 2).~~

~~Federal Home Loan Bank advances~~:

~~The~~following assumptions to estimate the fair value of ~~FHLB advances is estimated based on discounting~~PRSUs granted during February 2018 and 2017:



	Grant year
	2018		2017
Shares issued	5,550		6,089
Expected Term in Years	2.84		2.85
Weighted-Average Risk Free Interest Rate	2.39	%	1.40	%
Expected Dividend Yield	—	%	—	%
Weighted-Average Fair Value	27.69		24.39
Correlation coefficient	ABA NASDAQ Community Bank Index		ABA NASDAQ Community Bank Index
Range of peer company volatilities	18.99% - 51.42%		17.8% - 63.1%
Range of peer company correlation coefficients	28.16% - 94.29%		8.24% - 89.79%
Heritage volatility	22.3	%	21.8	%
Heritage correlation coefficient	76.44	%	75.93	%

For the ~~future cash flows using the market rate currently offered (Level 2).~~

~~Securities Sold Under Agreement to Repurchase~~:

~~Securities sold under agreement to repurchase are short-term in nature~~three and they reprice on a daily basis. Fair value financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).

~~Junior Subordinated Debentures:~~

The fair value is estimated using discounted cash flow analysis based on current rates for similar types of debt, which many be unobservable, and considering recent trading activity of similar instruments in markets which can be inactive (Level 3).

~~Off-Balance Sheet Financial Instruments~~:

The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans. As such, no premium or discount was ascribed to these commitments (Level 1). They are excluded from the preceding tables.


~~(15)~~	~~Commitments and Contingencies~~

~~In June 2016,~~nine months ended September 30, 2018, the Company received preliminary findings from the Washington State Department of Revenue ("DOR") regarding its business and occupation ("B&O") tax audit on the B&O tax returns of Whidbey Island Bank for the years 2010-2014. The state B&O tax is a gross receipts tax and is calculated on the gross income from activities. It is measured on the value of products, gross proceeds of sale, or gross income of the business. A substantial portion of the preliminary findingsrecognized compensation expense related to the ~~receipt~~units of ~~FDIC shared-loss payments from~~$523,000 and $1.3 million, respectively, and a related tax benefit of $110,000 and $274,000, respectively. For the ~~FDIC to Washington Banking Company in connection with its acquisitions of City Bank in April 2010~~three and ~~North County Bank in~~nine months ended September 2010. In their preliminary findings, the DOR is considering those payments as taxable for B&O tax purposes. The total amount of this preliminary finding, along with calculated back interest, is approximately $1.6 million. Management is in discussions with the DOR as to whether these payments should be taxable for B&O tax purposes. Given the uncertainty of the outcome of these discussions, management's estimates of the Company's ultimate liability, if any, involve significant judgment and are based on currently available information and an assessment of the validity of facts and calculations assumed by the DOR. Management does not believe a material loss is probable at this time and there are significant factual and legal issues to be resolved. Management believes that it is reasonably possible that future changes to the Company's estimates of loss and the ultimate amount paid for resolution of this B&O audit could impact the Company's results of operations in future periods. Any such losses would be reported as a noninterest expense in the Company's Consolidated Statement of Income.


~~(16)~~	~~Definitive Agreement~~

~~On July 26,~~30, 2017, the Company ~~announced~~recognized compensation expense related the ~~execution~~units of $236,000 and $472,000, respectively, and a ~~definitive agreement with Puget Sound under~~related tax benefit of $83,000 and $165,000, respectively. As of September 30, 2018, the total unrecognized compensation expense related to non-vested units was $4.0 million and the related weighted average period over which ~~Heritage will acquire Puget Sound in an all-stock transaction valued at~~the compensation expense is expected to be recognized is approximately $126.1 million based on the closing price of Heritage common stock of $27.15 on July 26, 2017. Puget Sound is a business bank headquartered in Bellevue, Washington with one branch location. Under the terms of the agreement, Puget Sound shareholders will receive 1.320 shares of Heritage common stock for each share of Puget Sound common stock, subject to potential adjustment.2.43 years. The vesting date fair value of the ~~consideration will fluctuate until closing based on~~units that vested during the ~~value of Heritage's stock price~~nine months ended September 30, 2018 was $1.0 million. There were no units that vested during the nine months ended September 30, 2017.

The following table summarizes the unit activity for the nine months ended September 30, 2018 and may be adjusted by a cap and collar in certain circumstances. The definitive agreement has been unanimously approved by the boards of directors of both Heritage and Puget Sound. The merger is subject to regulatory approvals, approval by Puget Sound shareholders and certain other customary closing conditions and is expected to close in the first quarter of 2018.2017:



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	—		$	—
Granted	92,019		25.29
Forfeited	(1,812	)	25.35
Nonvested at September 30, 2017	90,207		$	25.29

Nonvested at December 31, 2017	90,544		$	25.31
Granted	125,376		30.62
Vested	(32,375	)	25.44
Forfeited	(4,617	)	27.82
Nonvested at September 30, 2018	178,928		$	28.94

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(16)	Cash Requirement

The Company is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash. The required reserve balance at September 30, 2018 and December 31, 2017 was $22.6 million and $60,000, respectively, and was met by holding cash and maintaining an average balance with the Federal Reserve Bank.


ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three and nine months ended September 30, ~~2017.~~2018. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, and the December 31, ~~2016~~2017 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, ~~2016.~~2017.

Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality. At September 30, ~~2017,~~2018, we had total assets of ~~$4.05~~$5.28 billion and total stockholders’ equity of ~~$507.6~~$746.1 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.

Our business consists primarily of commercial lending and deposit relationships with small businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. We additionally originate for sale or for investment purposes one-to-four family residential loans on residential properties located primarily in our markets.

Our core profitability depends primarily on our net interest income. Net interest income is the difference between interest income, which is the income that we earn on interest earning assets, comprised primarily of loans and investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits. Management strives to match the repricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve. Like most financial institutions, our net interest income is affected significantly by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes on the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.

Our net income is affected by many factors, including the provision for loan losses. The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that we believe is appropriate to provide for probable incurred credit losses in our loan portfolio.

Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, gain on sale of loans (net) and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, professional services and data processing. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment, and consist primarily of lease payments, depreciation charges, maintenance, and costs of utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including account processing systems, electronic payments processing of products and services, and internet and mobile banking channels.

Results of operations may also be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities. Other income and other expenses are also impacted by growth of operations and growth in the number of loan and deposit accounts through acquisitions and core banking business growth.

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Earnings Summary

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

Net income was $15.5 million, or $0.42 per diluted common share, for the three months ended September 30, 2018 compared to $10.6 million, or $0.35 per diluted common share, for the three months ended September 30, ~~2017 compared to $11.0~~2017. Net income increased $4.9 million, or ~~$0.37 per diluted common share,~~45.9%, for the three months ended September 30, ~~2016. The $415,000, or 3.8% decrease in net income for the three months ended September 30, 2017~~2018 compared to the three months ended September 30, ~~2016 was~~2017 primarily ~~the result of a $1.5 million, or 14.9% decrease in noninterest~~

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~~income and a $1.1 million, or 4.2% increase in noninterest expense, partially offset by a $1.4 million, or 4.1%,~~due to an increase in net interest income of $16.2 million, or 46.2%, offset partially by anincrease in noninterest expense of $11.6 million, or 41.6%. The increases in net interest income and ~~a $611,000, or 40.9%, decrease in provision for loan losses.~~noninterest expense were primarily the result of the Premier and Puget Mergers with effective dates of January 16 and July 2, 2018.

Net interest income as a percentage of average interest earning assets (net interest margin) ~~decreased 10~~increased 55 basis points to ~~3.85%~~4.41% for the three months ended September 30, ~~2017~~2018 compared to ~~3.95%~~3.86% for the same period in ~~2016.~~2017. The increase in net interest margin was primarily due to increases in both the average loan balance and loan yield and secondarily in increases in both average balances and yields on investments, offset partially by an increase in the cost of interest bearing liabilities.

The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The Company’s efficiency ratio was ~~64.4%~~66.91% for the three months ended September 30, ~~2017~~2018 compared to ~~61.7%~~64.43% for the three months ended September 30, ~~2016 and~~2017. The change in the ~~change~~efficiency ratio was primarily attributable to ~~the decrease in noninterest income and~~ the increase in noninterest ~~expense.~~expense as a result of the Premier and Puget Mergers, including increases in compensation and employee benefits expense due to additional employees, occupancy and equipment expense primarily due to additional rent expense, and data processing expense due to an increase in transactional accounts and balances. Noninterest expense also increased $795,000 during the three months ended September 30, 2018 compared to the same period in 2017 due to amortization of intangible assets acquired in the Premier and Puget Mergers.

Comparison of nine months ended September 30, ~~2017~~2018 to the comparable period in the prior ~~year~~year.

Net income was $36.4 million, or $1.04 per diluted common share, for the nine months ended September 30, 2018 compared to $31.8 million, or $1.06 per diluted common share, for the nine months ended September 30, ~~2017 compared to $29.0~~2017. Net income increased $4.7 million, or ~~$0.97 per diluted common share,~~14.7%, for the nine months ended September 30, ~~2016. The $2.7 million, or 9.5% increase in net income for the nine months ended September 30, 2017~~2018 compared to the nine months ended September 30, ~~2016 was~~2017 primarily ~~the result of a $3.0 million, or 12.7%increase in noninterest income and a $2.9 million, or 2.9%,~~due to an increase in net interest income of $33.5 million, or 32.7%, partially offset by ~~a $3.3 million, or 4.2%~~an increase in noninterest ~~expense.~~expense of $29.1 million or 35.0%. The increases in net interest income and noninterest expense during the nine months ended September 30, 2018 compared to the same period in 2017 were primarily the result of the Premier and Puget Mergers.

The net interest margin ~~decreased 11~~increased 37 basis points to ~~3.89%~~4.26% for the nine months ended September 30, ~~2017~~2018 compared to ~~4.00%~~3.89% for the same period in ~~2016.~~2017. The increase in net interest margin was primarily due to increases in both the average loan balance and loan yield and secondarily due to increases in both the balances and yields on investments, offset partially by an increase in the cost of interest bearing liabilities.

The Company’s efficiency ratio ~~improved to 64.5%~~was 70.53% for the nine months ended September 30, ~~2017 from 64.8%~~2018 compared to 64.47% for the nine months ended September 30, ~~2016.~~2017. The ~~improvement~~change in the efficiency ratio for the nine months ended September 30, ~~2017~~2018 compared to the nine months ended September 30, ~~2016~~2017 was primarily attributable to additional noninterest expense as a result of the Premier and Puget Mergers, including increases in ~~noninterest income~~compensation and ~~net interest income.~~employee benefits expense due to additional employees, occupancy and equipment expense primarily due to additional rent expense, and data processing expense due to an increase in transactional accounts and balances. Noninterest expense also increased $1.7 million during the nine months ended September 30, 2018 compared to the same period in 2017 due to the amortization of intangible assets acquired in the Premier and Puget Mergers.

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Net Interest Income

One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest bearing deposits and other liabilities and stockholders' equity; the volume of noninterest earning assets; market interest rate fluctuations; and asset quality.

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

Net interest income increased ~~$1.4~~$16.2 million, or ~~4.1%~~46.2%, to ~~$35.0~~$51.1 million for the three months ended September 30, ~~2017~~2018 compared to ~~$33.6~~$34.9 million for the same period in ~~2016.~~2017. The increase in net interest income was primarily due to an increase in average interest earning assets, which increased substantially as a result of the Premier and Puget Mergers. Net interest income also increased due to increases in yields on interest earning assets primarily due to higher market interest rates reflecting increases in the target federal funds rate. The increase in net interest income was offset partially by an increase in the cost of total interest bearing liabilities primarily as a result of rising interest rates. The following table provides relevant net interest income information for the dates indicated.

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	Three Months Ended September 30,												Three Months Ended September 30,
	2017						2016						2018						2017
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾
	(Dollars in thousands)												(Dollars in thousands)
Interest Earning Assets:
Total loans receivable, net ^{(2) (3)}	$	2,737,535	$	32,595	4.72	%	$	2,526,150	$	30,915	4.87	%	$	3,618,031	$	48,301	5.30	%	$	2,737,535	$	32,595	4.72	%
Taxable securities	562,256		3,117		2.20		588,749		2,888		1.95		707,597		4,662		2.61		562,256		3,117		2.20
Nontaxable securities ⁽³⁾	229,683		1,354		2.34		225,994		1,235		2.17		176,322		1,085		2.44		229,683		1,354		2.34
Other interest earning assets	72,643		258		1.41		42,934		76		0.70		94,784		528		2.21		63,544		209		1.30
Total interest earning assets	3,602,117		37,324		4.11	%	3,383,827		35,114		4.13	%	4,596,734		54,576		4.71	%	3,593,018		37,275		4.12	%
Noninterest earning assets	418,100						408,634						681,831						427,199
Total assets	$	4,020,217					$	3,792,461					$	5,278,565					$	4,020,217
Interest Bearing Liabilities:
Certificates of deposit	$	394,345	$	633	0.64	%	$	378,407	$	468	0.49	%	$	512,547	$	1,184	0.92	%	$	394,345	$	633	0.64	%
Savings accounts	494,990		360		0.29		507,523		214		0.17		518,937		541		0.41		494,990		360		0.29
Interest bearing demand and money market accounts	1,499,335		635		0.17		1,480,220		587		0.16		2,044,236		1,289		0.25		1,499,335		635		0.17
Total interest bearing deposits	2,388,670		1,628		0.27		2,366,150		1,269		0.21		3,075,720		3,014		0.39		2,388,670		1,628		0.27
FHLB advances and other borrowings	111,293		428		1.53		5,618		8		0.57		20,892		117		2.22		111,293		428		1.53
Securities sold under agreement to repurchase	28,999		16		0.22		18,861		10		0.21		33,394		19		0.23		28,999		16		0.22
Junior subordinated debentures	19,897		261		5.20		19,602		221		4.49		20,181		330		6.49		19,897		261		5.20
Total interest bearing liabilities	2,548,859		2,333		0.36	%	2,410,231		1,508		0.25	%	3,150,187		3,480		0.44	%	2,548,859		2,333		0.36	%
Demand and other noninterest bearing deposits	916,074						844,468						1,314,203						916,074
Other noninterest bearing liabilities	50,022						44,378						69,786						50,022
Stockholders’ equity	505,262						493,384						744,389						505,262
Total liabilities and stockholders’ equity	$	4,020,217					$	3,792,461					$	5,278,565					$	4,020,217
Net interest income			$	34,991					$	33,606					$	51,096					$	34,942
Net interest spread					3.75	%					3.88	%					4.27	%					3.76	%
Net interest margin					3.85	%					3.95	%					4.41	%					3.86	%
Average interest earning assets to average interest bearing liabilities					141.32	%					140.39	%					145.92	%					140.97	%


⁽¹⁾	Annualized


⁽²⁾	The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.


⁽³⁾	Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

~~Interest Income~~

Total interest income increased $2.2 million, or 6.3%, to $37.3 million for the three months ended September 30, 2017 compared to $35.1 million for the same period in 2016. The balance of average interest earning assets increased $218.3 million, or 6.5%, to $3.60 billion for the three months ended September 30, 2017 from $3.38 billion for the three months ended September 30, 2016 and the average yield on total interest earning assets decreased two basis points to 4.11% for the three months ended September 30, 2017 compared to 4.13% for the three months ended September 30, 2016.

Interest income from interest and fees on loans increased $1.7 million, or 5.4%, to $32.6 million for the three months ended September 30, 2017 from $30.9 million for the same period in 2016 primarily due to an increase in average loans receivable of $211.4 million, or 8.4%, as a result of loan growth, offset partially by a 15 basis point decrease in the average loan yield to 4.72% for the three months ended September 30, 2017 from 4.87% for the three months ended September 30, 2016. The decrease in average loan yield was due primarily to a decrease in incremental accretion income on purchased loans and secondarily to a decrease in contractual note rates.

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Interest Income

Total interest income increased $17.3 million, or 46.4%, to $54.6 million for the three months ended September 30, 2018 compared to $37.3 million for the same period in 2017. The balance of average interest earning assets increased $1.00 billion, or 27.9%, to $4.60 billion for the three months ended September 30, 2018 from $3.59 billion for the three months ended September 30, 2017 and the yield on total interest earning assets increased 59 basis points to 4.71% for the three months ended September 30, 2018 compared to 4.12% for the three months ended September 30, 2017. The increase in the interest income was due primarily to interest income from interest and fees on loans and interest income on investment securities.

Interest income from interest and fees on loans increased $15.7 million, or 48.2%, to $48.3 million for the three months ended September 30, 2018 from $32.6 million for the same period in 2017 primarily due to an increase in average total loans receivable, net of $880.5 million, or 32.2%, as a result of loan growth which was substantially due to the Premier and Puget Mergers. Additionally, interest income from interest and fees on loans increased as the loan yield increased 58 basis points to 5.30% for the three months ended September 30, 2018 from 4.72% for the three months ended September 30, 2017. The increase in loan yield was due to a combination of higher contractual loan rates as a result of the increasing interest rate environment, an increase in loan yields from the loans acquired in the Premier and Puget Mergers as compared to legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due to loans acquired in the Premier and Puget Mergers.

Incremental accretion income was $2.6 million and $1.0 million for the three months ended September 30, 2018 and 2017, respectively. The increase in the incremental accretion during the three months ended September 30, 2018 was primarily due to accretion of loans acquired in the Premier and Puget Mergers. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.

The following table presents the ~~average~~ loan yield and effects of the incremental accretion on purchased loans for the three months ended September 30, ~~2017~~2018 and ~~2016:~~2017:

Three Months Ended September 30,
2017 2016
(Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.57 % 4.63 %
Impact on average loan yield from incremental accretion on purchased loans (1) 0.15 % 0.24 %
Average loan yield 4.72 % 4.87 %

Incremental accretion on purchased loans ⁽¹⁾
$ 1,036
$ 1,530



	Three Months Ended September 30,
	2018			2017
	(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾	5.01		%	4.57		%
Impact on loan yield from incremental accretion on purchased loans ⁽¹⁾	0.29			0.15
Loan yield	5.30		%	4.72		%

Incremental accretion on purchased loans ⁽¹⁾	$	2,637		$	1,036

⁽¹⁾

As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.

~~Incremental accretion~~

Interest income ~~was $1.0~~on investment securities increased $1.3 million, ~~and $1.5~~or 28.5%, to $5.7 million for the three months ended September 30, 2017 and 2016, respectively. The decrease in the incremental accretion was primarily a result of a continued decline in the purchased loan balances and a decrease in the prepayments of purchased loans during the three months ended September 30, ~~2017 compared to the same period in 2016. The incremental accretion is expected to continue to decrease as the balance of the purchased loans continues to decrease.~~

Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $348,000, or 8.4%, increase in interest income on investment securities to2018 from $4.5 million during the three months ended September 30, ~~2017 from $4.1~~2017. The increase in interest on investment securities was primarily a result of an increase in the average balance of investment securities of $92.0 million, ~~for~~or 11.6%, to $883.9 million during the three months ended September 30, 2016. The increase in income on investment securities was a result of an increase in average investment yields for the three months ended September 30, 2017 compared to the same period in 2016, offset partially by a decrease in the average balance of investment securities. Average yields on taxable securities increased 25 basis points to 2.20% for the three months ended September 30, 20172018 from 1.95% for the same period in 2016. Average yields on nontaxable securities increased 17 basis points to 2.34% for the three months ended September 30, 2017 from 2.17% for the same period in 2016. The average balance of investment securities decreased $22.8 million, or 2.8%, to $791.9 million during the three months ended September 30, ~~2017 from $814.7 million during~~2017. Additionally, interest income increased as a result an increase in the investment yields, reflecting the effect of the rise in interest rates on our adjustable rate investment securities and secondarily due to higher yields on new investment purchases for the three months ended September 30, ~~2016.~~2018 compared to the same period in 2017. Yields on taxable securities increased 41 basis points to 2.61% for the three months ended September 30, 2018 from 2.20% for the same period in 2017. Yields on nontaxable securities increased 10 basis points to 2.44% for the three months ended September 30, 2018 from 2.34% for the same period in 2017. The Company has actively managed its investment securities portfolio to ~~mitigate declining trends~~improve performance in ~~loan yields.~~the increasing rate environment.

~~Average~~Interest income on other interest earning assets increased ~~$29.7 million,~~$319,000, or ~~69.2%~~152.6%, due to ~~$72.6 million for the three months ended September 30, 2017 compared to $42.9 million for the three months ended September 30, 2016. The increase was due primarily to~~a combination of an increase in interest earning deposits as the Bank held more funds in interest earning accounts at the Federal Reserve Bank ~~of San Francisco~~ compared to the same period in 2017 and an increase in the ~~prior year.~~yields reflecting the rise in interest rates. Average

~~Interest Expense~~

~~Total~~

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other interest ~~expense~~earning assets increased ~~$825,000,~~$31.2 million, or ~~54.7%~~49.2%, to ~~$2.3~~$94.8 million for the three months ended September 30, ~~2017~~2018 compared to ~~$1.5~~$63.5 million for the three months ended September 30, 2017.

Interest Expense

Total interest expense increased $1.1 million, or 49.2%, to $3.5 million for the three months ended September 30, 2018 compared to $2.3 million for the same period in ~~2016.~~2017. The average cost of interest bearing liabilities increased 11eight basis points to 0.44% for the three months ended September 30, 2018 from 0.36% for the three months ended September 30, 2017 ~~from 0.25%~~as a result of the rise in market interest rates. Total average interest bearing liabilities increased $601.3 million, or 23.6%, to $3.15 billion for the three months ended September 30, ~~2016 as a result of increases in market rates. Total average interest bearing liabilities increased by $138.6 million, or 5.8%, to~~2018 from $2.55 billion for the three months ended September 30, 2017 substantially due to the Premier and Puget Mergers.

The cost of interest bearing deposits increased 12 basis points to 0.39% for the three months ended September 30, 2018 from ~~$2.41~~0.27% for the same period in 2017 due to a combination of an increase in market interest rates and an increase in the average balance due primarily to the Premier and Puget Mergers. The cost of interest bearing deposits is primarily due to the interest bearing demand and money market deposits and certificates of deposits. The average balance of interest bearing demand and money market deposits increased $544.9 million, or 36.3%, to $2.04 billion during the three months ended September 30, 2018 compared to $1.50 billion during the same period in 2017, and the cost of interest bearing demand and money market deposits increased eight basis points to 0.25% for the three months ended September 30, 2018 from 0.17% for the same period in 2017. The average balance of certificate of deposit accounts increased $118.2 million, or 30.0%, to $512.5 million for the three months ended September 30, 2018 compared to $394.3 million for the same period in 2017. The cost of certificates of deposit increased 28 basis points to 0.92% for the three months ended September 30, 2018 from 0.64% for the same period in 2017.

The Company was able to reduce the impact of the rising market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than the interest bearing deposits described above. The average balance of noninterest bearing deposits increased by $398.1 million, or 43.5%, to $1.31 billion for the three months ended September 30, ~~2016.~~

2018 compared to $916.0 million for the same period in 2017. The ~~average~~total cost of ~~interest bearing~~ deposits increased ~~six~~seven basis points to 0.27% for the three months ended September 30, ~~2017 from 0.21%~~2018 compared to 0.20% for the same period in ~~2016 primarily as a result of increases in both the average balance and cost of certificates of deposit and an increase in the average cost of savings accounts.~~2017.

Interest expense on ~~certificates of deposit increased $165,000,~~FHLB advances and other borrowings decreased $311,000, or ~~35.3%~~72.7%, to ~~$633,000 during~~$117,000 for the three months ended September 30, ~~2017~~2018 from ~~$468,000~~$428,000 for the same period in ~~2016~~2017 due to ~~increases~~the decrease in ~~the~~ average balance ~~and~~of FHLB advances during the ~~cost of the certificates of deposits accounts.~~quarter. The average balance ~~of certificates of deposits increased $15.9~~for FHLB advances and other borrowings decreased $90.4 million, or ~~4.2%~~81.2%, to ~~$394.3~~$20.9 million for the three months ended September 30, ~~2017~~2018 from ~~$378.4~~$111.3 million for the same period in ~~2016.~~2017. The Company was able to use the increase in the deposit balances to repay the FHLB advances as of September 30, 2018. The average cost of ~~certificates~~FHLB advances and other borrowings increase of ~~deposits increased 15~~69 basis points to ~~0.64%~~2.22% for the three months ended September 30, ~~2017 from 0.49%~~2018 compared to 1.53% for the same period in ~~2016.~~2017 was due to increases in market rates.

Net Interest Margin

Net interest margin increased 55 basis points for the three months ended September 30, 2018 to 4.41% from 3.86% for the same period in 2017 primarily due to the above mentioned changes in asset yields and costs of funds. The net interest spread increased 51 basis points for the three months ended September 30, 2018 to 4.27% from 3.76% for the same period in 2017 primarily due to the increase in yield earned on total interest earning assets.

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Interest expense on savings accounts increased $146,000, or 68.2%, to $360,000 during the three months ended September 30, 2017 from $214,000 for the same period in 2016 due primarily to the 12 basis point increase of the cost of the savings accounts to 0.29% for the three months ended September 30, 2017 from 0.17% for the same period in 2016.

Interest expense on FHLB advances and other borrowings increased $420,000, or 52.5%, to $428,000 for the three months ended September 30, 2018 from $8,000 for the same period in 2016 due to a combination of an increase in both average balances and cost of funds. The average balance for FHLB advances and other borrowings increased $105.7 million, or 1,881.0%, to $111.3 million for the three months ended September 30, 2017 from $5.6 million for the same period in 2016, due primarily to fund loan growth. The average rate of the FHLB advances for the three months ended September 30, 2017 was 1.53%, an increase of 96 basis points from 0.57% for the same period in 2016, due primarily to continued increases in short-term borrowing rates over the last year.

The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the three months ended September 30, 2017 was 5.20%, an increase of 71 basis points from 4.49% for the same period in 2016. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 1.33% at September 30, 2017 from 0.85% on September 30, 2016.

~~Net Interest Margin~~

Net interest margin for the three months ended September 30, 2017 decreased ten basis points to 3.85% from 3.95% for the same period in 2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the three months ended September 30, 2017 decreased 13 basis points to 3.75% from 3.88% for the same period in 2016. The decrease was primarily due to the above mentioned increases in the cost of funds of interest bearing liabilities.

Net interest margin is impacted by the incremental accretion on purchased loans. The following table presents the net interest margin and effects of the incremental accretion on purchased loans for the three months ended September 30, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended September 30,				Three Months Ended September 30,
	2017		2016		2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	3.74	%	3.77	%	4.18	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.11		0.18		0.23		0.11
Net interest margin	3.85	%	3.95	%	4.41	%	3.86	%

⁽¹⁾

Comparison of nine months ended September 30, ~~2017~~2018 to the comparable period in the prior year

Net interest income increased ~~$2.9~~$33.5 million, or ~~2.9%~~32.7%, to ~~$102.3~~$135.7 million for the nine months ended September 30, ~~2017~~2018 compared to ~~$99.5~~$102.2 million for the same period in ~~2016.~~2017. The following table provides relevant net interest income information for the dates indicated.

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	Nine Months Ended September 30,												Nine Months Ended September 30,
	2017						2016						2018						2017
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)
	(Dollars in thousands)												(Dollars in thousands)
Interest Earning Assets:
Total loans receivable, net (2) (3)	$	2,676,153	$	94,580	4.73	%	$	2,461,856	$	91,595	4.97	%	$	3,346,709	$	127,601	5.10	%	$	2,676,153	$	94,580	4.73	%
Taxable securities	565,528		9,307		2.20		594,301		8,522		1.92		645,866		12,259		2.54		565,528		9,307		2.20
Nontaxable securities (3)	225,583		3,926		2.33		220,038		3,599		2.18		200,179		3,646		2.44		225,583		3,926		2.33
Other interest earning assets	51,049		461		1.21		47,829		225		0.63		66,619		988		1.98		42,225		352		1.11
Total interest earning assets	3,518,313		108,274		4.11	%	3,324,024		103,941		4.18	%	4,259,373		144,494		4.54	%	3,509,489		108,165		4.12	%
Noninterest earning assets	418,837						391,342						596,239						427,661
Total assets	$	3,937,150					$	3,715,366					$	4,855,612					$	3,937,150
Interest Bearing Liabilities:
Certificates of deposit	$	369,724	$	1,527	0.55	%	$	397,070	$	1,496	0.50	%	$	451,741	$	2,741	0.81	%	$	369,724	$	1,527	0.55	%
Savings accounts	499,353		940		0.25		478,762		540		0.15		512,689		1,443		0.38		499,353		940		0.25
Interest bearing demand and money market accounts	1,489,149		1,834		0.16		1,457,399		1,729		0.16		1,863,135		2,985		0.21		1,489,149		1,834		0.16
Total interest bearing deposits	2,358,226		4,301		0.24		2,333,231		3,765		0.22		2,827,565		7,169		0.34		2,358,226		4,301		0.24
FHLB advances and other borrowings	106,556		870		1.09		11,608		47		0.54		45,194		669		1.98		106,556		870		1.09
Securities sold under agreement to repurchase	23,660		38		0.21		20,031		31		0.21		30,543		52		0.23		23,660		38		0.21
Junior subordinated debentures	19,823		748		5.05		19,527		647		4.43		20,108		928		6.17		19,823		748		5.05
Total interest bearing liabilities	2,508,265		5,957		0.32	%	2,384,397		4,490		0.25	%	2,923,410		8,818		0.40	%	2,508,265		5,957		0.32	%
Demand and other noninterest bearing deposits	885,467						811,043						1,201,676						885,467
Other noninterest bearing liabilities	47,283						35,266						64,686						47,283
Stockholders’ equity	496,135						484,660						665,840						496,135
Total liabilities and stockholders’ equity	$	3,937,150					$	3,715,366					$	4,855,612					$	3,937,150
Net interest income			$	102,317					$	99,451					$	135,676					$	102,208
Net interest spread					3.79	%					3.93	%					4.14	%					3.80	%
Net interest margin					3.89	%					4.00	%					4.26	%					3.89	%
Average interest earning assets to average interest bearing liabilities					140.27	%					139.41	%					145.70	%					139.92	%


⁽¹⁾	Annualized


⁽²⁾	The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.


⁽³⁾	Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

Interest Income

Total interest income increased ~~$4.3~~$36.3 million, or ~~4.2%~~33.6%, to ~~$108.3~~$144.5 million for the nine months ended September 30, ~~2017~~2018 compared to ~~$103.9~~$108.2 million for the same period in ~~2016.~~2017. The balance of average interest earning assets increased ~~$194.3~~$749.9 million, or ~~5.8%~~21.4%, to ~~$3.52~~$4.26 billion for the nine months ended September 30, 2018 from $3.51 billion for the nine months ended September 30, 2017 ~~from $3.32 billion for the nine months ended September 30, 2016~~ and the yield on total interest earning assets ~~decreased seven~~increased 42 basis points to ~~4.11%~~4.54% for the nine months ended September 30, ~~2017~~2018 compared to ~~4.18%~~4.12% for the nine months ended September 30, ~~2016.~~2017. The increase in the interest income was due primarily to interest income from interest and fees on loans and interest income on investment securities.

Interest income from interest and fees on loans increased ~~$3.0~~$33.0 million, or ~~3.3%~~34.9%, to ~~$94.6~~$127.6 million for the nine months ended September 30, ~~2017~~2018 from ~~$91.6~~$94.6 million for the same period in ~~2016~~2017 due primarily to an increase in average loans receivable, ~~offset partially by a decrease~~net and an increase in ~~average~~ loan yields. Average total loans receivable, net increased ~~$214.3~~$670.6 million, or ~~8.7%~~25.1%, to $3.35 billion for the nine months ended September 30, 2018 compared to $2.68 billion for the nine months ended September 30, 2017 ~~compared~~primarily as a result of the Premier and Puget Mergers. Loan yields increased 37 basis points to ~~$2.46 billion~~5.10% for the nine months ended September 30, ~~2016. Average loan yields decreased 24 basis points to~~2018 from 4.73% for the nine months ended September 30, 2017 ~~from 4.97% for the nine months ended September 30, 2016~~ due ~~mostly~~ to a ~~decrease~~combination of higher contractual loan rates as a result of the increasing interest rate environment, an increase in ~~incremental accretion income.~~loan yields from the loans acquired in the Premier and Puget Mergers as compared to

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legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due to loans acquired in the Premier and Puget Mergers.

Incremental accretion income was $6.3 million and $3.7 million for the nine months ended September 30, 2018 and 2017, respectively. The increase in the incremental accretion was primarily due to the accretion of the loans acquired in the Premier and Puget Sound Mergers. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.

The following table presents the ~~average~~ loan yield and effects of the incremental accretion on purchased loans for the nine months ended September 30, ~~2017~~2018 and ~~2016:~~2017:

Nine Months Ended September 30,
2017 2016
(Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.55 % 4.66 %
Impact on average loan yield from incremental accretion on purchased loans (1) 0.18 % 0.31 %
Average loan yield 4.73 % 4.97 %

Incremental accretion on purchased loans ⁽¹⁾
$ 3,687
$ 5,669

⁽¹⁾

Incremental accretion income was $3.7 million and $5.7 million for the nine months ended September 30, 2017 and 2016, respectively. The decrease in the incremental accretion was primarily a result of a continued decline in the purchased loan balances and a decrease in the prepayments of purchased loans during the nine months ended September 30, 2017 compared to the same period in 2016. The incremental accretion is expected to continue to decrease as the balance of the purchased loans continues to decrease.

Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $1.1 million, or 9.2%, increase in interest income on investment securities to $13.2 million during the nine months ended September 30, 2017 from $12.1 million for the nine months ended September 30, 2016. The increase in interest income on investment securities was the result of an increase in average investment yields for the nine months ended September 30, 2017 compared to the same period in 2016, offset partially by a decrease in the average balance of investment securities. Average yields on taxable securities increased 28 basis points to 2.20% for the nine months ended September 30, 2017 from 1.92% for the same period in 2016. Average yields on nontaxable securities increased 15 basis points to 2.33% for the nine months ended September 30, 2017 from 2.18% for the same period in 2016. The average balance of investment securities decreased $23.2 million, or 2.9%, to $791.1 million during the nine months ended September 30, 2017 from $814.3 million during the nine months ended September 30, 2016. The Company has actively managed its investment securities portfolio to mitigate declining, but recently improving, loan yields.

Average other interest earning assets increased $3.2 million, or 6.7%, to $51.0 million for the nine months ended September 30, 2017 compared to $47.8 million for the nine months ended September 30, 2016. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in 2016.

~~Interest Expense~~

Total interest expense increased $1.5 million, or 32.7%, to $6.0 million for the nine months ended September 30, 2017 compared to $4.5 million for the same period in 2016. The average cost of interest bearing liabilities increased seven basis points to 0.32% for the nine months ended September 30, 2017 from 0.25% for the nine months ended September 30, 2016. Total average interest bearing liabilities increased by $123.9 million, or 5.2%, to $2.51 billion for the nine months ended September 30, 2017 from $2.38 billion for the nine months ended September 30, 2016.

The average cost of interest bearing deposits increased two basis points to 0.24% for the nine months ended September 30, 2017 from 0.22% for the same period in 2016 due primarily to the changes in savings accounts.

Interest expense on savings accounts increased $400,000, or 74.1%, to $940,000 for the nine months ended September 30, 2017 from $540,000 for the same period in 2016 due to increases in both the average balance and cost of the savings accounts. The average balance of savings accounts increased $20.6 million, or 4.3%, to $499.4 million for the nine months ended September 30, 2017 from $478.8 million for the same period in 2016. The cost of savings accounts increased ten basis points to 0.25% for the nine months ended September 30, 2017 from 0.15% for the same period in 2016.

Interest expense of certificates of deposit accounts increased only $31,000, or 2.1%, to $1.5 million for the nine months ended September 30, 2017. The average balance of certificates of deposit decreased $27.3 million, or

~~Table of Contents~~

6.9%, to $369.7 million for the nine months ended September 30, 2017 compared to $397.1 million for the nine months ended September 30, 2016 while the cost of certificates of deposits increased to 0.55% for the nine months ended September 30, 2017 from 0.50% for the same period in 2016.

Interest expense on FHLB advances and other borrowings increased $823,000 to $870,000 for the nine months ended September 30, 2017 from $47,000 for the nine months ended September 30, 2016 due to a combination of an increase in average balances and an increase in the cost of funds. The average balance for FHLB advances and other borrowings increased $94.9 million to $106.6 million for the nine months ended September 30, 2017 from $11.6 million for the same period in 2016, due primarily to fund loan growth. The average rate of the FHLB advances and other borrowings for the nine months ended September 30, 2017 was 1.09%, an increase of 55 basis points from 0.54% for the same period in 2016.

The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the nine months ended September 30, 2017 was 5.05%, an increase of 62 basis points from 4.43% for the same period in 2016. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 1.33% at September 30, 2017 from 0.85% on September 30, 2016.

~~Net Interest Margin~~

Net interest margin for the nine months ended September 30, 2017 decreased 11 basis points to 3.89% from 4.00% for the same period in 2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the nine months ended September 30, 2017 decreased 14 basis points to 3.79% from 3.93% for the same period in 2016. This decrease was primarily due to the above mentioned decrease in average yields on total interest earning assets and increase in the average cost of funds of total interest bearing liabilities.

Nine Months Ended September 30,
2017 2016
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾
3.75 % 3.77 %
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾
0.14
0.23
Net interest margin 3.89 % 4.00 %



	Nine Months Ended September 30,
	2018			2017
	(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾	4.85		%	4.55		%
Impact on loan yield from incremental accretion on purchased loans⁽¹⁾	0.25			0.18
Loan yield	5.10		%	4.73		%

Incremental accretion on purchased loans ⁽¹⁾	$	6,261		$	3,687

⁽¹⁾

Interest income on investment securities increased $2.7 million, or 20.2%, to $15.9 million during the nine months ended September 30, 2018 compared to $13.2 million for the nine months ended September 30, 2017. The increase in interest income on investment securities was the result of a combination of an increase in investment yields for the nine months ended September 30, 2018 compared to the same period in 2017 and an increase in the average balance of investment securities during the period. Yields on taxable securities increased 34 basis points to 2.54% for the nine months ended September 30, 2018 compared to 2.20% for the same period in 2017. Yields on nontaxable securities increased 11 basis points to 2.44% for the nine months ended September 30, 2018 from 2.33% for the same period in 2017. The average balance of investment securities increased $54.9 million, or 6.9%, to $846.0 million during the nine months ended September 30, 2018 from $791.1 million during the nine months ended September 30, 2017. The Company reduced the balance of its tax exempt securities during the three months ended September 30, 2018 compared to the same period in 2017 as the tax effected yield was not as beneficial given the decrease in the federal corporate tax rate in 2018. The Company has actively managed its investment securities portfolio to improve performance in the increasing rate environment.

Income on other interest earning assets increased $636,000, or 180.7%, to $988,000 during the nine months ended September 30, 2018 compared to $352,000 during the same period in 2017 due to a combination of an increase in the average balances and an increase in market interest rates. Average other interest earning assets increased $24.4 million, or 57.8%, to $66.6 million for the nine months ended September 30, 2018 compared to $42.2 million for the nine months ended September 30, 2017. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in 2017. The yield on other interest earning assets increased 87 basis points to 1.98% during the nine months ended September 30, 2018 compared to 1.11% during the same period in 2017, reflecting a rise in market rates.

Interest Expense

Total interest expense increased $2.9 million, or 48.0%, to $8.8 million for the nine months ended September 30, 2018 compared to $6.0 million for the same period in 2017. The cost of interest bearing liabilities increased eight basis points to 0.40% for the nine months ended September 30, 2018 from 0.32% for the nine months ended September 30, 2017. The increase in costs was primarily a result of increases in market rates. Total average interest bearing liabilities increased by $415.1 million, or 16.6%, to $2.92 billion for the nine months ended September 30, 2018 from $2.51 billion for the nine months ended September 30, 2017 primarily as a result of the Premier and Puget Mergers.

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The cost of interest bearing deposits increased 10 basis points to 0.34% for the nine months ended September 30, 2018 from 0.24% for the same period in 2017 due to a combination of an increase in market interest rates and an increase in the average balance due primarily to the Premier and Puget Mergers. The cost of interest bearing deposits is primarily due to the interest bearing demand and money market deposits and certificates of deposits. The average balance of interest bearing demand and money market deposits increased $374.0 million, or 25.1%, to $1.86 billion during the nine months ended September 30, 2018 compared to $1.49 billion during the same period in 2017, and the cost of interest bearing demand and money market deposits increased five basis points to 0.21% for the nine months ended September 30, 2018 from 0.16% for the same period in 2017. The average balance of certificate of deposit accounts increased $82.0 million, or 22.2%, to $451.7 million for the nine months ended September 30, 2018 compared to $369.7 million for the same period in 2017. The cost of certificates of deposit increased 26 basis points to 0.81% for the nine months ended September 30, 2018 from 0.55% for the same period in 2017.

The Company was able to reduce the impact of the rising market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than the noninterest bearing deposits described above. The average balance of noninterest bearing deposits increased by $316.2 million, or 35.7%, during the nine months ended September 30, 2018 to $1.20 billion compared to $885.5 million for the same period in 2017. The cost of all deposit accounts increased to 0.24% for the nine months ended September 30, 2018 compared to 0.18% for the nine months ended September 30, 2017.

Interest expense on FHLB advances and other borrowings decreased $201,000, or 23.1%, to $669,000 for the nine months ended September 30, 2018 from $870,000 for the nine months ended September 30, 2017 due to a decrease in the average balance, partially offset by an increase in the cost. The average balance for FHLB advances and other borrowings decreased $61.4 million to $45.2 million for the nine months ended September 30, 2018 from $106.6 million for the same period in 2017 due to the increase in the average deposit balances. The average rate of the FHLB advances and other borrowings increased 89 basis points to 1.98% for the nine months ended September 30, 2018 compared to 1.09% for the same period in 2017 as a result of the increase in market rates.

The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, increased 112 basis points to 6.17% for the nine months ended September 30, 2018 compared to 5.05% for the same period in 2017. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 2.40% at September 30, 2018 from 1.33% on September 30, 2017.

Net Interest Margin

Net interest margin for the nine months ended September 30, 2018 increased 37 basis points to 4.26% from 3.89% for the same period in 2017 primarily due to the above mentioned changes in asset yields and costs of funds in addition to an increase in incremental accretion on purchased loans as a result of the Premier and Puget Mergers. The net interest spread for the nine months ended September 30, 2018 increased 34 basis points to 4.14% from 3.80% for the same period in 2017 primarily due to the increase in yield on total interest earning assets.



	Nine Months Ended September 30,
	2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	4.06	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.20		0.14
Net interest margin	4.26	%	3.89	%

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Provision for Loan Losses

The Bank has established a comprehensive methodology for determining its allowance for loan losses. The allowance for loan losses is increased by provisions for loan losses charged to expense, and is reduced by loans charged-off, net of loan recoveries or a recovery of previous provision. The amount of the provision expense recognized during the three and nine months ended September 30, 2018 and 2017 was calculated in accordance with the Bank's methodology. For additional information, see the section entitled "Analysis of Allowance for Loan Losses" below.

The provision for loan losses is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, a decline in general economic conditions could increase future provisions for loan losses and have a material effect on the Company’s net income.

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

The provision for loan losses ~~decreased $611,000,~~increased $181,000, or ~~40.9%~~20.5%, to ~~$884,000~~$1.1 million for the three months ended September 30, ~~2017~~2018 from ~~$1.5 million~~$884,000 for the three months ended September 30, ~~2016.~~2017. The ~~decrease~~increase in the provision for loan losses for the three months ended September 30, ~~2017~~2018 from the same period in ~~2016~~2017 was primarily the result of increases in total loan balances as a ~~change in the composition~~result of ~~the loan portfolio, changes in certain environmental factors and improvements in certain historical loss factors.~~mergers. Based on a thorough review of the loan portfolio, the Bank determined that the provision for

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loan losses for the three months ended September 30, ~~2017~~2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

Comparison of nine months ended September 30, ~~2017~~2018 to the comparable period in the prior year

The provision for loan losses ~~decreased $872,000,~~increased $1.1 million, or ~~23.2%~~37.6% to $4.0 million for the nine months ended September 30, 2018 from $2.9 million for the nine months ended September 30, ~~2017 from $3.8 million for the nine months ended September 30, 2016.~~2017. The ~~decrease~~increase in the provision for loan losses for the nine months ended September 30, ~~2017~~2018 from the same period in ~~2016~~2017 was primarily the result of ~~a change in~~ the ~~volume and mix of loans,~~same changes ~~in certain environmental factors and improvements in certain historical loss factors.~~mentioned above for the increase during the three months ended September 30, 2018. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the nine months ended September 30, ~~2017~~2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

Noninterest Income

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

Total noninterest income decreased ~~$1.5 million,~~$363,000, or ~~14.9%~~4.3%, to ~~$8.4~~$8.1 million for the three months ended September 30, ~~2017~~2018 compared to ~~$9.9~~$8.4 million for the same period in ~~2016.~~2017. The following table presents the change in the key components of noninterest income for the periods noted.


	Three Months Ended September 30,									Three Months Ended September 30,
	2017		2016		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Service charges and other fees	$	4,769	$	3,630	$	1,139		31.4	%	$	4,824	$	4,769	$	55		1.2	%
Gain on sale of investment securities, net	44		345		(301		)	(87.2	)	82		44		38			86.4
Gain on sale of loans, net	1,229		3,435		(2,206		)	(64.2	)	706		1,229		(523		)	(42.6	)
Interest rate swap fees	328		742		(414		)	(55.8	)	—		328		(328		)	(100.0	)
Other income	2,024		1,715		309			18.0		2,468		2,073		395			19.1
Total noninterest income	$	8,394	$	9,867	$	(1,473	)	(14.9	)%	$	8,080	$	8,443	$	(363	)	(4.3	)%

Gain on ~~the~~ sale of loans, net and interest rate swap fees decreased ~~$2.2 million, or 64.2% to $1.2 million for~~based on a decline in volume of U.S. Small Business Administration ("SBA") loan sales and new swap contracts, respectively, during the three months ended September 30, ~~2017~~2018 compared to ~~$3.4 million~~ the same period in ~~2016, due~~2017. These declines are attributed primarily to ~~a $2.1 million gain on sale of a previously classified purchased credit impaired loan recognized in 2016.~~the increasing market rates. The detail of gain on sale of loans, net is included in the following schedule.

Three Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Mortgage loans $ 875
$ 1,087
$ (212 ) (19.5 )%
SBA loans 354
285
69
24.2
Other loans —
2,063
(2,063 ) (100.0 )
Total gain on sale of loans, net $ 1,229
$ 3,435
$ (2,206 ) (64.2 )%

Interest rate swap fees decreased $414,000, or 55.8% to $328,000 for the three months ended September 30, 2017 compared to $742,000 the same period in 2016, due primarily to a decrease in the number of swaps executed during the three months ended September 30, 2017 compared to the three months ended September 30, 2016.

The decrease in noninterest income was partially offset by an increase in service charges and other fees of $1.1 million, or 31.4% to $4.8 million for the three months ended September 30, 2017 compared to $3.6 million for the same period in 2016, due primarily to a consumer deposit account consolidation process completed at the end of 2016 and a business deposit consolidation process completed during second quarter 2017 and the related changes in fee structures, as well as increases in deposit balances.

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	Three Months Ended September 30,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Gain on sale of mortgage loans, net	$	706	$	875	$	(169	)	(19.3	)%
Gain on sale of guaranteed portion of SBA loans, net	—		354		(354		)	(100.0	)
Gain on sale of loans, net	$	706	$	1,229	$	(523	)	(42.6	)%

These decreases in noninterest income were offset partially by an increase in other income of $395,000, or 19.1% to $2.5 million for the three months ended September 30, 2018 compared to $2.1 million for the same period in 2017, due primarily to a gain on sale of a branch held for sale of $382,000 recognized during the three months ended September 30, 2018.

Comparison of nine months ended September 30, ~~2017~~2018 to the comparable period in the prior year

Total noninterest income ~~increased $3.0~~decreased $3.3 million, or ~~12.7%~~12.5%, to ~~$26.4~~$23.2 million for the nine months ended September 30, ~~2017~~2018 compared to ~~$23.4~~$26.5 million for the same period in ~~2016.~~2017. The following table presents the change in the key components of noninterest income for the periods noted.


	Nine Months Ended September 30,									Nine Months Ended September 30,
	2017		2016		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Service charges and other fees	$	13,408	$	10,462	$	2,946		28.2	%	$	14,062	$	13,408	$	654		4.9	%
Gain on sale of investment securities, net	161		1,106		(945		)	(85.4	)	135		161		(26		)	(16.1	)
Gain on sale of loans, net	6,562		5,406		1,156			21.4		2,286		6,562		(4,276		)	(65.2	)
Interest rate swap fees	743		1,105		(362		)	(32.8	)	360		743		(383		)	(51.5	)
Other income	5,532		5,354		178			3.3		6,358		5,641		717			12.7
Total noninterest income	$	26,406	$	23,433	$	2,973		12.7	%	$	23,201	$	26,515	$	(3,314	)	(12.5	)%

~~Service charges and other fees increased $2.9~~Gain on sale of loans, net decreased $4.3 million, or ~~28.2%~~65.2% to ~~$13.4~~$2.3 million for the nine months ended September 30, ~~2017~~2018 compared to ~~$10.5~~$6.6 million for the same period in ~~2016,~~2017, due primarily to the gain on sale of a ~~consumer deposit account consolidation process completed at~~purchased credit impaired loan of $3.0 million recognized during the ~~end of 2016 and a business deposit consolidation process completed during second quarter 2017 and the related changes in fee structures, as well as increases in deposit balances.~~

nine months ended September 30, 2017. Gain on sale of mortgage and SBA loans ~~net increased $1.2~~also decreased during the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to less activity. Proceeds from sale of mortgage loans and the guaranteed portion of SBA loans decreased $33.4 million, or ~~21.4%~~31.3% to ~~$6.6~~$73.3 million for the nine months ended September 30, ~~2017 compared to $5.4~~2018 from $106.7 million for the same period in 2016, due primarily to a $935,000 increase in sale of other loans. During each of the nine months ended September 30, 2017 and 2016, the Bank sold one loan previously classified as purchased credit impaired. In addition, gain on sale of SBA loans increased $272,000 due primarily to an increase in proceeds from sale of SBA loans of $7.8 million, or 90.9%, to $16.4 million for the nine months ended September 30, 2017 compared to $8.6 million for the same period in 2016.2017. The detail of gain on sale of loans, net is included in the following schedule.

Nine Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Mortgage loans $ 2,515
$ 2,566
$ (51 ) (2.0 )%
SBA loans 1,049
777
272
35.0
Other loans 2,998
2,063
935
45.3
Total gain on sale of loans, net $ 6,562
$ 5,406
$ 1,156
21.4 %



	Nine Months Ended September 30,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Gain on sale of mortgage loans, net	$	1,930	$	2,515	$	(585	)	(23.3	)%
Gain on sale of guaranteed portion of SBA loans, net	356		1,049		(693		)	(66.1	)
Gain on sale of other loans, net	—		2,998		(2,998		)	(100.0	)
Gain on sale of loans, net	$	2,286	$	6,562	$	(4,276	)	(65.2	)%

The ~~increase in noninterest income was partially offset by a~~ decrease in gain on sale of ~~investment securities,~~loans, net was offset partially by an increase in other income of ~~$945,000,~~$717,000, or ~~85.4%,~~12.7% to ~~$161,000 for the nine months ended September 30, 2017 from $1.1~~$6.4 million for the nine months ended September 30, ~~2016. The decrease was~~2018 compared to $5.6 million for the same period in 2017, due primarily ~~the result of fewer sales as the Bank actively managed its investment portfolio. The proceeds from~~to a gain on sale of ~~investment securities was $21.9~~a branch held for sale of $382,000 recognized during the three months ended September 30, 2018 and an increase in merchant VISA income of $198,000 primarily due to an increase in customer account activity and a favorable contract renewal with the existing vendor.

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Service charges and other fees also increased $654,000, or 4.9% to $14.1 million for the nine months ended September 30, ~~2017~~2018 compared to ~~$94.4~~$13.4 million for the same period in ~~2016.~~2017, due primarily to an increase in deposit balances from acquisition and organic growth and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017.

Noninterest Expense

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

Noninterest expense increased ~~$1.1~~$11.6 million, or ~~4.2%~~41.6%, to ~~$28.0~~$39.6 million during the three months ended September 30, ~~2017~~2018 compared to ~~$26.8~~$28.0 million for the three months ended September 30, ~~2016. The following table presents changes in the key components of noninterest expense for the periods noted.~~

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Three Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Compensation and employee benefits $ 15,823
$ 15,633
$ 190
1.2 %
Occupancy and equipment 3,979
3,926
53
1.3
Data processing 2,090
1,943
147
7.6
Marketing 933
745
188
25.2
Professional services 1,453
830
623
75.1
State and local taxes 640
820
(180 ) (22.0 )
Federal deposit insurance premium 433
296
137
46.3
Other real estate owned, net (88 ) (142 ) 54
(38.0 )
Amortization of intangible assets 319
359
(40 ) (11.1 )
Other expense 2,373
2,408
(35 ) (1.5 )
Total noninterest expense $ 27,955
$ 26,818
$ 1,137
4.2 %

Professional services increased $623,000, or 75.1%, to $1.5 million during the three months ended September 30, 2017 from $830,000 during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 compared to the same period in 2016 was primarily due to legal costs incurred for our pending merger with Puget Sound as discussed in Note (16) Definitive Agreement as well as benefit-based consulting fees related to the consumer and business deposit account consolidation processes, which correspondingly generated an increase in service charges and other fees.

Compensation and employee benefits increased $190,000, or 1.2%, to $15.8 million during the three months ended September 30, 2017 from $15.6 million during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 compared to the same period in 2016 was primarily due to senior level staffing increases and standard salary increases.

The ratio of noninterest expense to average assets (annualized) was 2.76% for the three months ended September 30, 2017 compared to 2.81% for the three months ended September 30, 2016. The decrease was primarily a result of an increase in assets and cost efficiencies gained through efforts by the Company to manage noninterest expenses.

~~Comparison of nine months ended September 30, 2017 to the comparable period in the prior year~~

~~Noninterest expense increased $3.3 million, or 4.2%, to $83.0 million during the nine months ended September 30, 2017 compared to $79.7 million for the nine months ended September 30, 2016.~~2017. The following table presents changes in the key components of noninterest expense for the periods noted.


	Nine Months Ended September 30,										Three Months Ended September 30,
	2017			2016		Change			Percentage Change		2018		2017			Change			Percentage Change
	(Dollars in thousands)										(Dollars in thousands)
Compensation and employee benefits	$	48,119		$	45,652	$	2,467		5.4	%	$	23,804	$	15,823		$	7,981		50.4	%
Occupancy and equipment	11,607			11,873		(266		)	(2.2	)	5,020		3,979			1,041			26.2
Data processing	6,007			5,564		443			8.0		2,343		2,090			253			12.1
Marketing	2,545			2,254		291			12.9		876		933			(57		)	(6.1	)
Professional services	3,515			2,508		1,007			40.2		2,119		1,453			666			45.8
State and local taxes	1,828			2,031		(203		)	(10.0	)	931		640			291			45.5
Federal deposit insurance premium	1,090			1,316		(226		)	(17.2	)	375		433			(58		)	(13.4	)
Other real estate owned, net	(36		)	330		(366		)	(110.9	)	18		(88		)	106			(120.5	)
Amortization of intangible assets	966			1,057		(91		)	(8.6	)	1,114		319			795			249.2
Other expense	7,346			7,079		267			3.8		2,997		2,373			624			26.3
Total noninterest expense	$	82,987		$	79,664	$	3,323		4.2	%	$	39,597	$	27,955		$	11,642		41.6	%

The Company has incurred significant non-recurring acquisition costs in the Premier and Puget Mergers. The following table presents these expenses by key component in the following table.



	Three Months Ended September 30,
	2018		2017
	(Dollars in thousands)
Compensation and employee benefits	$	1,907	$	—
Occupancy and equipment	7		—
Data processing	370		—
Marketing	1		—
Professional services	1,081		384
Other expense	36		3
Total acquisition costs	$	3,402	$	387

Compensation and employee benefits increased $8.0 million, or 50.4%, to $23.8 million during the three months ended September 30, 2018 from $15.8 million during the three months ended September 30, 2017 primarily as a result of additional employees, primarily due to the Premier and Puget Mergers. The average full time equivalent employees increased to 878 for the three months ended September 30, 2018 compared to 747 for the same period in 2017, including employees acquired in the Premier Merger. Compensation and employee benefits additionally increased due to standard salary increases and acquisition-related payments related primarily to the Premier Merger of $1.9 million during the three months ended September 30, 2018.

Occupancy and equipment increased $1.0 million, or 26.2%, to $5.0 million during the three months ended September 30, 2018 from $4.0 million during the three months ended September 30, 2017 due substantially to branch expansion in the Seattle, Bellevue, Portland and other Oregon markets. The Bellevue expansion included the lease

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acquired from the Puget Sound Merger and additional space leased subsequent to the merger. The Oregon expansion included five leases acquired in the Premier Merger.

Amortization of intangible assets increased $795,000, or 249.2%, to $1.1 million during the three months ended September 30, 2018 from $319,000 during the three months ended September 30, 2017 primarily a result of additional amortization related to acquired core deposit intangibles from the Premier and Puget Mergers of $836,000 during the three months ended September 30, 2018.

Professional services increased $666,000, or 45.8%, to $2.1 million during the three months ended September 30, 2018 from $1.5 million during the three months ended September 30, 2017 as a result of merger activities including legal and conversion consulting costs.

The ratio of noninterest expense to average total assets (annualized) was 2.98% for the three months ended September 30, 2018 compared to 2.76% for the three months ended September 30, 2017. The increase was primarily a result of increased expenses as a result of the Premier and Puget Mergers.

Comparison of nine months ended September 30, 2018 to the comparable period in the prior year

Noninterest expense increased $29.1 million, or 35.0%, to $112.1 million during the nine months ended September 30, 2018 compared to $83.0 million for the nine months ended September 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.



	Nine Months Ended September 30,
	2018		2017			Change			Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	64,492	$	48,119		$	16,373		34.0	%
Occupancy and equipment	14,457		11,607			2,850			24.6
Data processing	7,455		6,007			1,448			24.1
Marketing	2,507		2,545			(38		)	(1.5	)
Professional services	8,485		3,515			4,970			141.4
State and local taxes	2,335		1,828			507			27.7
Federal deposit insurance premium	1,105		1,090			15			1.4
Other real estate owned, net	18		(36		)	54			(150.0	)
Amortization of intangible assets	2,705		966			1,739			180.0
Other expense	8,491		7,346			1,145			15.6
Total noninterest expense	$	112,050	$	82,987		$	29,063		35.0	%

The Company has incurred significant non-recurring acquisition costs in the Premier and Puget Mergers. The following table presents these expenses by key component in the following table.



	Nine Months Ended September 30,
	2018		2017
	(Dollars in thousands)
Compensation and employee benefits	$	4,798	$	—
Occupancy and equipment	44		—
Data processing	1,147		—
Marketing	6		—
Professional services	3,016		384
Other expense	79		3
Total acquisition costs	$	9,090	$	387

Compensation and employee benefits increased ~~$2.5~~$16.4 million, or ~~5.4%~~34.0%, to $64.5 million during the nine months ended September 30, 2018 from $48.1 million during the nine months ended September 30, ~~2017 from $45.7 million during the nine months ended September 30, 2016.~~2017. The increase in the nine months ended September 30, ~~2017~~2018 compared to ~~the same period in 2016~~2017 was primarily as a result of additional employees, primarily due to the Premier and Puget Mergers, including increases in senior level ~~staffing~~staffing. The average full time equivalent employees increased to 831 for the nine months ended September 30, 2018 compared to 754 for the same

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period in 2017, including employees acquired in the Premier and Puget Mergers. Compensation and employee benefits additionally increased due to increases ~~including the addition of the new Portland, Oregon lending team members who started~~ in ~~May 2017, and~~ standard salary ~~increases.~~and acquisition-related payments related to the Premier and Puget Mergers of $4.8 million during the nine months ended September 30, 2018.

Professional services increased ~~$1.0~~$5.0 million, or ~~40.2%~~141.4%, to $8.5 million during the nine months ended September 30, 2018 from $3.5 million during the nine months ended September 30, 2017 ~~from $2.5~~primarily due to an increase of $2.6 million in professional services acquisition costs. The increase was additionally the result of the buy-out of a third party contract in the amount of $1.7 million during the nine months ended September 30, ~~2016.~~2018. The ~~increase~~Company expects the accumulated savings in future professional services expenses to fully offset the cost of the buy-out by the end of 2019.

Occupancy and equipment increased $2.9 million, or 24.6%, to $14.5 million during the nine months ended September 30, 2018 from $11.6 million during the nine months ended September 30, 2017 ~~compared~~due substantially to branch expansion in the Seattle, Bellevue, Portland and other Oregon markets. The Bellevue expansion included the lease acquired from the Puget Sound Merger and additional space leased subsequent to the ~~same period~~merger. The Oregon expansion included five leases acquired in ~~2016 was~~the Premier Merger.

Amortization of intangible assets increased $1.7 million, or 180.0%, to $2.7 million during the nine months ended September 30, 2018 from $966,000 during the nine months ended September 30, 2017 primarily due to due to benefit-based consulting fees related to the consumer deposit account consolidation process, which correspondingly generated an increase in service charges and other fees. Professional services also increased as a result of ~~Trust-related expenses based on a renegotiated contract for 2017, which also increased other noninterest income,~~additional amortization related to acquired core deposit intangibles from the Premier and ~~legal costs incurred for our pending merger with~~ Puget ~~Sound as discussed in Note (16) Definitive Agreement.~~Mergers of $1.9 million during the nine months ended September 30, 2018.

Data processing increased ~~$443,000,~~$1.4 million, or ~~8.0%~~24.1%, to $7.5 million during the nine months ended September 30, 2018 from $6.0 million during the nine months ended September 30, 2017 ~~from $5.6 million during~~primarily due to acquisition costs. The increase in the nine months ended September 30, ~~2016 primarily~~2018 compared to 2017 was additionally due to higher transactional activity ~~in the core operating system and internet banking~~ as a result of the Premier and Puget Mergers and organic growth in loans and ~~deposits..~~

Other real estate owned, net decreased $366,000 or 110.9%, to income of $36,000 during the nine months ended September 30, 2017 compared to expense of $330,000 during the nine months ended September 30, 2016. The income recorded during the nine months ended September 30, 2017 was due to gain on sale of properties of $111,000, offset by maintenance expense of $75,000. For the nine months ended September 30, 2016, the Bank recorded a valuation adjustment of $383,000 and maintenance expense of $120,000, which was offset by the gain on sale of properties of $173,000.deposits.

The ratio of noninterest expense to average total assets (annualized) was 3.09% for the nine months ended September 30, 2018, compared to 2.82% for the nine months ended September 30, ~~2017, compared to 2.86% for~~2017. The increase was primarily a result of increased expenses including acquisition related costs as a result of the Premier and Puget Mergers during the nine months ended September 30, ~~2016. The decrease was primarily a result of an increase in assets and cost efficiencies gained through efforts by the Company to manage noninterest expenses.~~2018.

Income Tax Expense

Comparison of quarter ended September 30, ~~2017~~2018 to the comparable quarter in the prior ~~year~~year.

Income tax expense decreased ~~by $199,000,~~$912,000, or ~~4.8%~~23.3%, to $3.0 million for the three months ended September 30, 2018 from $3.9 million for the three months ended September 30, ~~2017 from $4.1 million~~2017. The effective tax rate was 16.3% for the three months ended September 30, ~~2016. The effective tax rate was 27.0% for the three months ended September 30, 2017~~2018 compared to ~~27.2%~~27.0% for the same period in ~~2016.~~2017. The decrease in the income tax expense and effective tax rate during the ~~three~~nine months ended September 30, ~~2017 compared~~2018 was primarily due to the ~~same period~~impact of the Tax Cuts and Jobs Actenacted in ~~2016 was due primarily~~December 2017, which lowered the corporate income tax rate to ~~an increase in tax benefits~~21% from low income housing tax credits, offset partially by the implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises and restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.35%.

Comparison of nine months ended September 30, ~~2017~~2018 to the comparable period in the prior year

Income tax expense ~~increased by $645,000,~~decreased $4.7 million, or ~~6.2%~~42.2%, to $6.4 million for the nine months ended September 30, 2018 from $11.1 million for the nine months ended September 30, ~~2017 from $10.4 million~~2017. The effective tax rate was 15.0% for the nine months ended September 30, ~~2016. The effective tax rate was 25.9% for the nine months ended September 30, 2017~~2018 compared to ~~26.5%~~25.9% for the same period in ~~2016.~~2017. The decrease in the income tax expense and effective tax rate during the nine months ended September 30, ~~2017 compared~~2018 was primarily due to the ~~same period in 2016 was due primarily to~~impact of the ~~implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises~~Tax Cuts and ~~restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.~~

~~Financial Condition Overview~~

Total assets increased $171.1 million, or 4.4%, to $4.05 billion as of September 30, 2017 compared to $3.88 billion as of December 31, 2016. Total loans receivable, net, increased $156.4 million, or 6.0%, to $2.77 billion at September 30, 2017 compared to $2.61 billion at December 31, 2016. Loans were mostly funded throughJobs Act, offset partially by an increase in deposits. Deposits increased by $91.2 million, or 2.8%, to $3.32 billion as of September 30, 2017 compared to $3.23 billion as of December 31, 2016. Total non-maturity deposits decreased to 88.1% of total deposits at September 30, 2017 from 88.9% at December 31, 2016 and certificates of deposits increased to 11.9% of total deposits at ~~September 30, 2017 from 11.1% at December 31, 2016.~~certain non-deductible acquisition costs.

Prepaid expenses and other assets increased $8.4 million, or 10.6%, to $87.7 million at September 30, 2017 from $79.4 million at December 31, 2016 primarily as a result of the Company's investment in two new low income housing tax credit partnerships totaling $14.3 million. These investments had corresponding obligations recorded in accrued expenses and other liabilities of $14.3 million at September 30, 2017. These obligations will decrease as

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projects in the partnerships are funded. During the nine months ended September 30, 2017 the Company made capital contributions related to other low income housing tax credit partnerships of $8.5 million, partially offsetting the increase in accrued expenses and other liabilities.

Federal Home Loan Bank advances increased $37.8 million, or 47.5%, to $117.4 million as of September 30, 2017 from $79.6 million as of December 31, 2016. The increase in advances was required as a supplement to deposits in order to fund loan growth.

Total stockholders’ equity increased $25.8 million, or 5.4%, to $507.6 million as of September 30, 2017 from $481.8 million at December 31, 2016. The increase during the nine months ended September 30, 2017 was due primarily to net income of $31.8 million and a $4.4 million improvement in accumulated other comprehensive income, net of tax, offset partially by cash dividends declared of $11.4 million. The Company’s equity position was 12.5% of total assets as of September 30, 2017 and 12.4% as of December 31, 2016.Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, ~~2016~~2017 to September 30, ~~2017.~~2018, and the results of the Puget Sound Merger effective January 16, 2018 and the Premier Merger effective July 2, 2018:


	September 30, 2017		December 31, 2016			Change			Percent Change		September 30, 2018			December 31, 2017			Change			% Change		Fair Value of Premier and Puget Mergers at Respective Merger Dates
	(Dollars in thousands)										(Dollars in thousands)
Assets
Cash and cash equivalents	$	111,258	$	103,745		$	7,513		7.2	%	$	170,143		$	103,015		$	67,128		65.2	%	$	105,974
Investment securities	800,060		794,645			5,415			0.7
Investment securities available for sale, at fair value											920,737			810,530			110,207			13.6		84,846
Loans held for sale	5,368		11,662			(6,294		)	(54.0	)	1,882			2,288			(406		)	(17.7	)	—
Total loans receivable, net	2,766,113		2,609,666			156,447			6.0		3,614,579			2,816,985			797,594			28.3		718,547
Other real estate owned	523		754			(231		)	(30.6	)	2,032			—			2,032			N/A		1,796
Premises and equipment, net	60,457		63,911			(3,454		)	(5.4	)	80,439			60,325			20,114			33.3		3,785
Federal Home Loan Bank stock, at cost	9,343		7,564			1,779			23.5		6,076			8,347			(2,271		)	(27.2	)	1,743
Bank owned life insurance	71,474		70,355			1,119			1.6		93,296			75,091			18,205			24.2		17,116
Accrued interest receivable	12,295		10,925			1,370			12.5		15,735			12,244			3,491			28.5		2,454
Prepaid expenses and other assets	87,728		79,351			8,377			10.6		108,730			99,328			9,402			9.5		3,182
Other intangible assets, net	6,408		7,374			(966		)	(13.1	)	21,728			6,088			15,640			256.9		18,345
Goodwill	119,029		119,029			—			—		240,837			119,029			121,808			102.3		121,808
Total assets	$	4,050,056	$	3,878,981		$	171,075		4.4	%	$	5,276,214		$	4,113,270		$	1,162,944		28.3	%	$	1,079,596

Liabilities
Deposits	$	3,320,818	$	3,229,648		$	91,170		2.8		$	4,398,127		$	3,393,060		$	1,005,067		29.6	%	$	824,602
Federal Home Loan Bank advances	117,400		79,600			37,800			47.5		—			92,500			(92,500		)	(100.0	)	16,000
Junior subordinated debentures	19,936		19,717			219			1.1		20,229			20,009			220			1.1		—
Securities sold under agreement to repurchase	28,668		22,104			6,564			29.7		32,233			31,821			412			1.3		462
Accrued expenses and other liabilities	55,626		46,149			9,477			20.5		79,492			67,575			11,917			17.6		8,489
Total liabilities	3,542,448		3,397,218			145,230			4.3		4,530,081			3,604,965			925,116			25.7		849,553
Stockholders' equity
Common stock	360,113		359,060			1,053			0.3		591,065			360,590			230,475			63.9		230,043
Retained earnings	145,677		125,309			20,368			16.3		169,758			149,013			20,745			13.9		—
Accumulated other comprehensive income (loss), net	1,818		(2,606		)	4,424			169.8
Accumulated other comprehensive loss, net											(14,690		)	(1,298		)	(13,392		)	1,031.7		—
Total stockholders' equity	507,608		481,763			25,845			5.4		746,133			508,305			237,828			46.8		230,043
Total liabilities and stockholders' equity	$	4,050,056	$	3,878,981		$	171,075		4.4	%	$	5,276,214		$	4,113,270		$	1,162,944		28.3	%	$	1,079,596

Total assets increased $1.16 billion, or 28.3%, to $5.28 billion as of September 30, 2018 compared to $4.11 billion as of December 31, 2017. The Premier and Puget Mergers resulted in an increase of total assets, including goodwill, of $1.08 billion at their respective merger dates.

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~~Lending Activities~~

~~As indicated in the table below,~~Total loans receivable, net, ~~was $2.80 billion at September 30, 2017, an increase of $156.8~~excluding loans acquired in the Premier and Puget Mergers increased $79.0 million, or ~~5.9%, from $2.64 billion at December 31, 2016. The increase in loans receivable for~~3.8% annualized, during the nine months ended September 30, 2018.

Investment securities increased $110.2 million, or 13.6%, to $920.7 million at September 30, 2018 from $810.5 million at December 31, 2017 primarily as a result of investment purchases, offset partially by maturities, calls and payments of investment securities. The investment securities acquired in the Puget Sound Merger were sold shortly after the merger.

Deposits, excluding the Premier and Puget Mergers, increased $180.5 million, or 7.1% annualized, during the nine months ended September 30, 2018. Brokered deposits increased $18.6 million, or 46.9%, to $58.1 million at September 30, 2018 compared to $39.6 million at December 31, 2017. Total non-maturity deposits increased to 88.5% of total deposits at September 30, 2018 from 88.3% at December 31, 2017 and certificates of deposit decreased to 11.5% of total deposits at September 30, 2018 from 11.7% at December 31, 2017.

The Company had no Federal Home Loan Bank advances at September 30, 2018, a $92.5 million decrease from December 31, 2017. The Company was able to repay the higher cost of funding based on the increase in the deposit balances primarily as a result of the Premier and Puget Mergers.

Total stockholders’ equity increased $237.8 million, or 46.8%, to $746.1 million as of September 30, 2018 from $508.3 million at December 31, 2017. The Company’s stockholders' equity position was 14.1% of total assets as of September 30, 2018 and 12.4% as of December 31, 2017. Changes in stockholders' equity during the nine months ended September 30, 2018 were as follows:



	Nine Months Ended
	September 30, 2018
	(In thousands)
Balance, beginning of period	$	508,305
Common stock issued in the Premier and Puget Mergers	230,043
Net income	36,448
Dividends declared	(15,796		)
Accumulated other comprehensive loss	(13,299		)
Other	432
Balance, end of period	$	746,133

Lending Activities

The Bank is a full service commercial bank, which originates a wide variety of loans with a focus on commercial business loans. Total loans receivable, net of allowance for loan losses, increased $797.6 million, or 28.3%, to $3.61 billion at September 30, 2018 from $2.82 billion at December 31, 2017. The increase in loans receivable was primarily due to ~~increases in~~the Premier and Puget Mergers. At the merger dates, the Bank acquired fair value of commercial ~~business~~and industrial loans of ~~$121.3~~$271.8 million, ~~consumer~~non-owner occupied commercial real estate loans of ~~$15.5~~$185.0 million, and owner-occupied commercial real estate ~~construction and land development~~ loans of ~~$15.3~~$183.6 million.

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The following table provides information about our loan portfolio by type of loan at the dates indicated and the change between these dates. These balances are prior to deduction for the allowance for loan losses.


	September 30, 2017				December 31, 2016				September 30, 2018				December 31, 2017
	Balance		% of Total		Balance		% of Total		Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾		Change		%of Balance Change
	(Dollars in thousands)								(Dollars in thousands)
Commercial business:
Commercial and industrial	$	665,582	23.8	%	$	637,773	24.2	%	$	861,530	23.6	%	$	645,396	22.7	%	$	216,134	33.5	%
Owner-occupied commercial real estate	602,238		21.5		558,035		21.1		785,416		21.5		622,150		21.8		163,266		26.2
Non-owner occupied commercial real estate	930,188		33.3		880,880		33.4		1,283,160		35.2		986,594		34.6		296,566		30.1
Total commercial business	2,198,008		78.6		2,076,688		78.7		2,930,106		80.3		2,254,140		79.1		675,966		30.0
One-to-four family residential(1)	81,422		2.9		77,391		2.9		96,333		2.7		86,997		3.1		9,336		10.7
Real estate construction and land development:
One-to-four family residential	51,451		1.8		50,414		1.9		107,148		2.9		51,985		1.8		55,163		106.1
Five or more family residential and commercial properties	122,981		4.4		108,764		4.1		120,787		3.3		97,499		3.4		23,288		23.9
Total real estate construction and land development(2)	174,432		6.2		159,178		6.0		227,935		6.2		149,484		5.2		78,451		52.5
Consumer	340,643		12.2		325,140		12.3		391,283		10.7		355,091		12.5		36,192		10.2
Gross loans receivable	2,794,505		99.9		2,638,397		99.9		3,645,657		99.9		2,845,712		99.9		799,945		28.1
Deferred loan costs, net	3,008		0.1		2,352		0.1
Net deferred loan costs									3,397		0.1		3,359		0.1		38		1.1
Loans receivable, net	$	2,797,513	100.0	%	$	2,640,749	100.0	%	$	3,649,054	100.0	%	$	2,849,071	100.0	%	$	799,983	28.1	%

⁽¹⁾ Excludes loans held for sale of $1.9 million, and $2.3 million as of September 30, 2018 and December 31, 2017, respectively.

⁽²⁾ Balances do not include undisbursed loan commitments.

⁽³⁾ Percent of loans receivable, net.

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Nonperforming Assets and Credit Quality Metrics

The following table ~~describes~~provides information about our ~~nonperforming assets~~nonaccrual loans, other real estate owned and ~~other credit quality metrics at~~performing TDR loans for the ~~dates indicated:~~indicated dates.


	September 30, 2017			December 31, 2016			September 30, 2018			December 31, 2017
	(Dollars in thousands)						(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	9,683		$	8,580		$	13,487		$	9,098
One-to-four family residential	84			94			74			81
Real estate construction and land development	869			2,008			1,076			1,247
Consumer	316			227			143			277
Total nonaccrual loans ~~(2)~~(1)	10,952			10,909			14,780			10,703
Other real estate owned	523			754			2,032			—
Total nonperforming assets	$	11,475		$	11,663		$	16,812		$	10,703

Allowance for loan losses	$	31,400		$	31,083		$	34,475		$	32,086
Nonperforming loans to loans receivable, net							0.41		%	0.38		%
Allowance for loan losses to loans receivable, net	1.12		%	1.18		%	0.94		%	1.13		%
Allowance for loan losses to nonperforming loans	286.71		%	284.93		%	233.25		%	299.79		%
Nonperforming loans to loans receivable, net	0.39		%	0.41		%
Nonperforming assets to total assets	0.28		%	0.30		%	0.32		%	0.26		%

Performing TDR loans:
Commercial business	$	18,571		$	19,837		$	23,970		$	25,729
One-to-four family residential	219			227			211			218
Real estate construction and land development	1,136			2,141			—			645
Consumer	118			83			268			165
Total performing TDR loans ~~(3)~~	$	20,044		$	22,288		$	24,449		$	26,757
Accruing loans past due 90 days or more ~~(4)~~	$	—		$	—		$	—		$	—
Potential problem loans ~~(5)~~	84,089			87,762			105,742			83,543


⁽¹⁾	At September 30, ~~2017~~2018 and December 31, ~~2016, $5.9~~2017, $6.5 million and ~~$6.9~~$5.2 million of ~~nonperforming~~nonaccrual loans ~~respectively,~~ were considered TDR ~~loans.~~


⁽²⁾	~~At September 30, 2017 and December 31, 2016, $2.5 million and $2.8 million of nonperforming~~ loans, ~~respectively, were guaranteed by government agencies.~~


⁽³⁾	~~At September 30, 2017 and December 31, 2016, $1.4 million and $682,000 of performing TDR loans, respectively, were guaranteed by government agencies.~~


⁽⁴⁾	~~There were no accruing loans past due 90 days or more that were guaranteed by government agencies at September 30, 2017 or December 31, 2016.~~


⁽⁵⁾	~~At September 30, 2017 and December 31, 2016, $1.7 million and $1.1 million of potential problem loans, respectively, were guaranteed by government agencies.~~respectively.

~~Nonperforming assets were $11.5~~Nonaccrual Loans. Nonaccrual loans increased $4.1 million to $14.8 million, or ~~0.28%~~0.41% of ~~total assets and $11.7 million, or 0.30% of total assets as of September 30, 2017 and December 31, 2016, respectively. The balance of nonaccrual~~ loans ~~increased $43,000, or 0.4%, to $11.0 million ($2.5 million guaranteed by governmental agencies)~~receivable, net, at September 30, ~~2017~~2018 from ~~$10.9~~$10.7 million, ~~($2.8 million guaranteed by governmental agencies)~~or 0.38% of loans receivable, net, at December 31, ~~2016. For~~2017. The increase was due primarily to two agricultural loan relationships and two commercial business relationships that were transferred to nonaccrual status during the nine months ended September 30, ~~2017, the increase in nonaccrual loans was primarily due to additions to nonaccrual loans of $5.1 million, offset partially by net principal reductions of $4.3~~2018 totaling $1.7 million and ~~charge-offs of $750,000. The other real estate owned balance decreased to $523,000~~$1.9 million, respectively, at September 30, ~~2017 from $754,000 at December 31, 2016 primarily as a result~~2018. One of the ~~sale~~agricultural relationships is well-secured and the Company did not record a related allowance for loan losses and the other agricultural relationship is partially guaranteed by the SBA and the Company recorded an allowance for loan losses of ~~two properties.~~

~~Performing TDR loans were $20.0 million and $22.3 million as of~~$76,000 at September 30, ~~2017 and December 31, 2016, respectively. The $2.2 million, or 10.1%, decrease in performing TDR loans~~2018 related to the unguaranteed portion of the loan. We recorded an allowance for loan losses of $564,000 for the ~~nine months ended~~two commercial business relationships at September 30, 2017 was primarily the result of net principal payments of $8.3 million and loans transferred to nonaccrual of $1.1 million, partially offset by troubled loans restructured during the period of $7.1 million. At September 30, 2017 and2018.

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~~December 31, 2016,~~The following table reflects the ~~Company had an allowance for loan losses on the performing TDR~~changes in nonaccrual loans ~~of $2.1 million and $2.0 million, respectively.~~

Potential problem loans as of September 30, 2017 and December 31, 2016 were $84.1 million and $87.8 million, respectively. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes concerns as to their ability to meet their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are both well secured and in the process of collection. The $3.7 million, or 4.2%, decrease in potential problem loans was primarily the result of net principal payments of $18.9 million, loans transferred to held for sale of $5.8 million, loans transferred to nonaccrual status of $4.6 million and loan grade improvements of $4.4 million, partially offset by the addition of loans graded as potential problem loans of $31.4 million during the nine months ended September 30, 2018:



	Nine Months Ended
	September 30, 2018
	(In thousands)
Nonaccrual loans
Balance, beginning of period	$	10,703
Addition of previously classified pass graded loans	5,373
Addition of previously classified potential problem loans	4,336
Addition of acquired loans	130
Charge-offs	(724		)
Net principal payments	(5,038		)
Balance, end of period	$	14,780

At September 30, 2018, nonaccrual loans of $8.9 million had related allowance for loan losses of $2.2 million and nonaccrual loans of $5.9 million had no related allowance for loan losses. At December 31, 2017 nonaccrual loans of $3.8 million had related allowance for loan losses of $720,000 and nonaccrual loans of $6.9 million had no allowance for loan losses.

At September 30, 2018, nonperforming TDR loans, included in the nonaccrual loan table above, were $6.5 million and had a related allowance for loan losses of $713,000. At December 31, 2017, nonperforming TDR loans were $5.2 million and had a related allowance for loan losses of $379,000.

Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $6.1 million to $16.8 million, or 0.32% of total assets at September 30, 2018 from $10.7 million, or 0.26% of total assets, at December 31, 2017 due to primarily to the increase in nonaccrual loans discussed above. Nonperforming assets additionally increased due to the additions of other real estate owned, primarily as a result of other real estate owned acquired in the Premier Merger. There was no other real estate owned at December 31, 2017.

Troubled Debt Restructured Loans. TDR loans are considered impaired and are separately measured for impairment whether on accrual or nonaccrual status. The performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite being considered impaired due to the restructured status. Performing TDR loans decreased $2.3 million, or 8.6%, to $24.4 million at September 30, 2018 from $26.8 million at December 31, 2017.

The following table reflects the changes in performing TDR loans during nine months ended September 30, 2018:



	Nine Months Ended
	September 30, 2018
	(In thousands)
Performing TDR loans
Balance, beginning of period	$	26,757
Addition of previously classified pass graded loans	1,909
Addition of previously classified potential problem loans	907
Net principal payments	(5,124		)
Balance, end of period	$	24,449

The related allowance for loan losses on performing TDR loans was $2.2 million as of September 30, 2018 and $2.6 million as of December 31, 2017.

Potential Problem Loans. Potential problem loans increased $22.2 million, or 26.6%, to $105.7 million at September 30, 2018 from $83.5 million at December 31, 2017. The increase was due primarily to the addition of an agricultural lending relationship totaling $15.7 million at September 30, 2018 and the addition of potential problem loans acquired in the Premier and Puget Mergers with a total outstanding balance of $10.1 million and $4.5 million, respectively.

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The following table reflects the changes in potential problem loans during the nine months ended September 30, 2018 (in thousands):



	Nine Months Ended
	September 30, 2018
	(In thousands)
Potential problem loans
Balance, beginning of period	$	83,543
Addition of previously classified pass graded loans	48,915
Acquired in Premier and Puget Mergers	14,630
Net principal payments	(20,530		)
Upgrades to pass graded loan status	(15,273		)
Transfers of loan to nonaccrual or troubled debt restructured status	(5,243		)
Charge-offs	(300		)
Balance, end of period	$	105,742

Analysis of Allowance for Loan Losses

~~Management maintains an~~The allowance for loan losses ~~(“ALL”)~~is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be appropriate to ~~provide for estimated~~absorb probable incurred credit losses in the loan portfolio at the balance sheet date. The ~~adequacy of~~allowance for loan losses is determined by applying estimated loss factors to the ~~ALL is monitored through our ongoing quarterly loan quality assessments.~~credit exposure from outstanding loans.

We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:

•~~Historical~~historical loss experience in the loan portfolio;

•~~Impact~~impact of environmental factors, including:


▪◦	~~Levels~~levels of and trends in delinquencies, ~~and~~ classified and impaired loans;


▪◦	~~Levels~~levels of and trends in charge-offs and recoveries;


▪◦	~~Trends~~trends in volume and terms of loans;


▪◦	~~Effects~~effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;


▪◦	~~Experience,~~experience, ability, and depth of lending management and other relevant staff;


▪◦	~~National~~national and local economic trends and conditions;


▪◦	~~Other~~other external factors such as competition, legal and regulatory;


▪◦	~~Effects~~effects of changes in credit concentrations; and


▪◦	~~Other~~other factors

We calculate an appropriate ~~ALL~~allowance for loan losses for the loans in our loan portfolio ~~except PCI loans,~~ by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and ~~TDRs,~~TDR loans, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate ~~ALL~~allowance for loan losses combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.

The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology described above except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments recorded at the time the loans were purchased are additionally factored into the allowance methodology.

For the PCI loans, the acquisition date fair value incorporated our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the PCI loan portfolio will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the previously recognized provision for that loan or pool of loans, if any, and then prospectively recognized in interest income as a yield adjustment.

While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and

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results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of an additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.

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The following table provides information regarding changes in our allowance for loan losses ~~as of~~at and for the three and nine months ended September 30, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016			2018			2017			2018			2017
	(Dollars in thousands)
Loans receivable, net at the end of the period	$	2,797,513		$	2,578,977		$	2,797,513		$	2,578,977
Average loans receivable during the period	2,737,535			2,526,150			2,676,153			2,461,856
													(Dollars in thousands)
Allowance for loan losses on loans at the beginning of the period	$	32,751		$	28,426		$	31,083		$	29,746		$	33,972		$	32,751		$	32,086		$	31,083
Provision for loan losses	884			1,495			2,882			3,754			1,065			884			3,967			2,882
Charge-offs:
Commercial business	(1,497		)	(328		)	(1,940		)	(3,698		)	(300		)	(1,497		)	(923		)	(1,940		)
One-to-four family residential	(15		)	—			(15		)	—			(15		)	(15		)	(30		)	(15		)
Real estate construction and land development	(556		)	—			(556		)	(154		)	—			(556		)	—			(556		)
Consumer	(478		)	(572		)	(1,419		)	(1,370		)	(530		)	(478		)	(1,709		)	(1,419		)
Total charge-offs	(2,546		)	(900		)	(3,930		)	(5,222		)	(845		)	(2,546		)	(2,662		)	(3,930		)
Recoveries:
Commercial business	8			993			834			1,352			121			8			690			834
One-to-four family residential	—			—			1			2			—			—			—			1
Real estate construction and land development	191			—			201			83			3			191			5			201
Consumer	112			197			329			496			159			112			389			329
Total recoveries	311			1,190			1,365			1,933			283			311			1,084			1,365
Net (charge-offs) recoveries	(2,235		)	290			(2,565		)	(3,289		)	(562		)	(2,235		)	(1,578		)	(2,565		)
Allowance for loan losses at the end of the period	$	31,400		$	30,211		$	31,400		$	30,211		$	34,475		$	31,400		$	34,475		$	31,400

Allowance for loan losses to loans receivable, net	1.12		%	1.17		%	1.12		%	1.17		%	0.94		%	1.12		%	0.94		%	1.12		%
Net charge-offs (recoveries) on loans to average loans, annualized	0.32		%	(0.05		)%	0.13		%	0.18		%
Net charge-offs on loans to average loans, annualized													0.06		%	0.32		%	0.06		%	0.13		%

Loans receivable, net at the end of the period ⁽¹⁾													$	3,649,054		$	2,797,513		$	3,649,054		$	2,797,513
Average loans receivable during the period ⁽¹⁾													3,618,031			2,737,535			3,346,709			2,676,153

⁽¹⁾ Excludes loans held for sale.

The allowance for loan losses increased $2.4 million, or 7.4%, to ~~$31.4~~$34.5 million at September 30, ~~2017~~2018 from ~~$31.1~~$32.1 million at December 31, ~~2016.~~2017. The increase was the result of provision for loan losses of ~~$2.9~~$4.0 million ~~partially offset by net charge-offs of $2.6 million recorded~~recognized during the nine months ended September 30, ~~2017, which included PCI loan pool~~2018, offset partially by net charge-offs of ~~$1.7 million.~~$1.6 million recorded during the same period. The allowance for loan losses to loans receivable, net, decreased to ~~1.12%~~0.94% at September 30, ~~2017~~2018 from ~~1.18%~~1.13% at December 31, ~~2016.~~2017 primarily as a result of an increase in loans from the Premier and Puget Merger with no related allowance for loan losses in accordance with GAAP. Included in the carrying value of loans are net discounts on loans purchased in mergers and acquisitions which may reduce the need for an allowance for loan losses on these loans because they are carried at an amount below the outstanding principal balance. The remaining net discount on purchased loans, including the related fair value discount acquired in the Premier and Puget Mergers, was $13.4 million at September 30, 2018 compared to $10.1 million at December 31, 2017.

The ratio of net charge-offs (recoveries) on loans to average loans, annualized deteriorated to net charge-off of 0.32% for the three months ended September 30, 2017 compared to net recoveries of 0.05% for the three months ended September 30, 2016, primarily due to PCI loan poolCompany recorded charge-offs of ~~$1.5~~$2.7 million for the three months ended September 30, 2017. The ratio of net charge-offs (recoveries) on loans to average loans, annualized improved to a net charge-off of 0.13% for the nine months ended September 30, 2017 from 0.18% for the nine months ended September 30, 2016. The improvement of the ratio was due primarily to fewer net charge-offs recorded during the nine months ended September 30, ~~2017 compared~~2018 due primarily as a result of a large volume of small dollar consumer loans. The largest charge-offs recognized during the nine months ended September 30, 2018 related to ~~the same period in 2016 in addition to growth~~two agricultural relationships and one commercial relationship in the ~~loan portfolio.~~

~~Nonperforming loans were $11.0~~amount of $724,000. The Company recorded recoveries of $1.1 million ~~and $10.9 million at~~during the nine months ended September 30, ~~2017 and December 31, 2016, respectively, or 0.39% and 0.41%~~2018 primarily a result of ~~loans receivable, net, respectively. The allowance for loan losses to nonperforming loans was 286.71% at September 30, 2017 and 284.93% at December 31, 2016. As~~small recoveries on a large volume of September 30, 2017, the Bank identified $31.0 million of impaired loans, of which $10.5 million had no specific valuation allowance as their estimated collateral value or discounted estimated cash flow was equal to or exceeds their carrying value. The remaining $20.5 million of impaired loans at September 30, 2017 had related specific valuation allowances totaling $3.1 million. Impaired loans totaled $33.2 million at December 31, 2016, of which $10.1 million had no specific valuation allowance and $23.1 million had $2.7 million of specific valuation allowance.small dollar consumer loans.

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As of September 30, 2018, the Bank identified $14.8 million of nonperforming loans and $24.4 million of performing TDR loans for a total of $39.2 million of impaired loans. Of these impaired loans, $9.2 million had no allowances for loan losses as their estimated collateral value or discounted expected cash flow is equal to or exceeds their carrying costs. The remaining $30.0 million of impaired loans had related allowances for loan losses totaling $4.5 million. As of December 31, 2017, the Bank identified $10.7 million of nonperforming loans and $26.8 million of performing TDR loans for a total of $37.5 million of impaired loans. Of these impaired loans, $10.4 million had no allowances for loan losses. The remaining $27.1 million of impaired loans had related allowances for loan losses totaling $3.4 million.

The following table outlines the allowance for loan losses and related loan balances on loans at September 30, 2018 and December 31, 2017:



	September 30, 2018			December 31, 2017
	(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses	$	26,705		$	24,732
Gross loans, excluding PCI and impaired loans	$	3,577,575		$	2,767,650
Percentage	0.75		%	0.89		%

PCI Allowance:
Allowance for loan losses	$	3,296		$	3,999
Gross PCI loans	$	28,853		$	40,603
Percentage	11.42		%	9.85		%

Specific Valuation Allowance:
Allowance for loan losses	$	4,474		$	3,355
Gross impaired loans	$	39,229		$	37,459
Percentage	11.40		%	8.96		%

Total Allowance for Loan Losses:
Allowance for loan losses	$	34,475		$	32,086
Gross loans receivable	$	3,645,657		$	2,845,712
Percentage	0.95		%	1.13		%

Based on the Bank's established comprehensive methodology, management deemed the allowance for loan losses of ~~$31.4~~$34.5 million at September 30, ~~2017~~2018 (0.94% of loans receivable, net and 233.25% of nonperforming loans) appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at that date. This compares to an allowance for loan losses at December 31, ~~2016~~2017 of ~~$31.1 million. At~~$32.1 million (1.13% of loans receivable, net and 299.79% of nonperforming loans).

While we believe we use the ~~applicable acquisition or merger dates, no~~best information available to determine the allowance for loan losses, ~~was established on purchased loans as~~our results of operations could be significantly affected if circumstances differ substantially from the ~~loans were accounted for at their fair value~~assumptions used in determining the allowance. A decline in national and local economic conditions, or other factors, could result in a ~~discount was established for the loans. At September 30, 2017 and December 31, 2016, the remaining fair value discount for these purchased loans was $11.7 million and $13.5 million, respectively.~~

~~The following table outlines~~material increase in the allowance for loan losses and ~~related loan balances at September 30, 2017~~may adversely affect the Company’s financial condition and ~~December 31, 2016:~~

September 30, 2017 December 31, 2016
(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses $ 24,113
$ 21,791
Gross loans, excluding PCI and impaired loans $ 2,719,813
$ 2,540,751
Percentage 0.89 % 0.86 %

PCI Allowance:
Allowance for loan losses $ 4,176
$ 6,558
Gross PCI loans $ 43,696
$ 64,448
Percentage 9.56 % 10.18 %

Specific Valuation Allowance:
Allowance for loan losses $ 3,111
$ 2,734
Gross impaired loans $ 30,996
$ 33,198
Percentage 10.04 % 8.24 %

Total Allowance for Loan Losses:
Allowance for loan losses $ 31,400
$ 31,083
Gross loans receivable $ 2,794,505
$ 2,638,397
Percentage 1.12 % 1.18 %

~~While~~results of operations. In addition, the ~~Bank believes it has established its existing allowances~~determination of the amount of the allowance for loan losses ~~in accordance with U.S. GAAP, there can be no assurance that~~is subject to review by bank regulators, as part of their routine examination process, which may result in ~~reviewing~~ the ~~Bank’s loan portfolio, will not request the Bank to increase significantly its~~establishment of an additional allowance for loan ~~losses. In addition, because~~losses based upon their judgment of information available to them at the time of their examination. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is appropriate or that increased provisions will not be necessary should the ~~credit~~ quality of the loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company’s financial condition and results of operations.

Based on management’s assessment of loan quality and current economic conditions, the Company believes that its allowance for loan losses was appropriate to absorb the probable incurred losses and inherent risks of loss in the loan portfolio at September 30, 2017.

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Deposits and Other Borrowings

~~As indicated in the table below, total~~Total deposits ~~were $3.32~~increased $1.01 billion, or 29.6%, to $4.40 billion at September 30, ~~2017, an increase of $91.2 million, or 2.8%,~~2018 from ~~$3.23~~$3.39 billion at December 31, ~~2016.~~

September 30, 2017 December 31, 2016
Balance % of Total Balance % of Total
(Dollars in thousands)
Noninterest bearing demand deposits $ 916,265
27.6 % $ 882,091
27.3 %
Interest bearing demand deposits 1,031,449
31.0
963,821
29.8
Money market accounts 480,899
14.5
523,875
16.2
Savings accounts 497,024
15.0
502,460
15.6
Total non-maturity deposits 2,925,637
88.1
2,872,247
88.9
Certificates of deposit 395,181
11.9
357,401
11.1
Total deposits $ 3,320,818
100.0 % $ 3,229,648
100.0 %

~~Non-maturity deposits (total deposits less certificates of deposit) increased $53.4 million, or 1.9%, to $2.93 billion at September 30,~~ 2017 ~~from $2.87 billion at December 31, 2016. Certificate of deposit accounts increased $37.8 million, or 10.6%, to $395.2 million at September 30, 2017 from $357.4 million at December 31, 2016~~ due primarily to the ~~addition of $44.1 million of brokered certificates of deposit, which were used to supplement deposit growth~~deposits acquired in the ~~funding~~Premier and Puget Mergers of ~~loan growth. Based on~~$824.6 million at the ~~change in the mix~~respective merger dates. Non-maturity deposits as a percentage of total deposits increased to 88.5% at September 30, 2018 from 88.3% at December 31, 2017 and ~~volume of deposits,~~ the percentage of certificates of deposit to total deposits ~~increased~~decreased to ~~11.9%~~11.5% at September 30, ~~2017~~2018 from ~~11.1%~~11.7% at December 31, ~~2016.~~2017 primarily as a result of the mix of deposits acquired from the Premier and Puget Mergers.

The following table summarizes the Company's deposits as of September 30, 2018 and December 31, 2017:



	September 30, 2018				December 31, 2017
	Balance		% of Total		Balance		% of Total		Change		%of Balance Change
	(Dollars in thousands)
Noninterest demand deposits	$	1,311,825	29.8	%	$	944,791	27.8	%	$	367,034	38.8	%
Interest bearing demand deposits	1,294,105		29.4		1,051,752		31.1		242,353		23.0
Money market accounts	768,998		17.5		499,618		14.7		269,380		53.9
Savings accounts	519,596		11.8		498,501		14.7		21,095		4.2
Total non-maturity deposits	3,894,524		88.5		2,994,662		88.3		899,862		30.0
Certificate of deposit accounts	503,603		11.5		398,398		11.7		105,205		26.4
Total deposits	$	4,398,127	100.0	%	$	3,393,060	100.0	%	$	1,005,067	29.6

Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. The Bank is utilizing securities sold under agreement to repurchase as a supplement to its funding sources. Our repurchase agreements are secured by available for sale investment securities. At September 30, ~~2017,~~2018, the Bank had securities sold under agreement to repurchase of ~~$28.7~~$32.2 million, an increase of ~~$6.6 million,~~$412,000, or ~~29.7%~~1.3%, from ~~$22.1~~$31.8 million at December 31, ~~2016.~~2017. The increase was the result of customer activity during the ~~period.~~period and to a lesser extent securities sold under agreement to repurchase acquired in the Premier Merger.

The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was ~~$19.9~~$20.2 million at September 30, ~~2017,~~2018, which reflects the fair value of the junior subordinated debentures established during the Washington Banking Merger, adjusted for the accretion of discount from purchase accounting fair value adjustment.

At September 30, ~~2017,~~2018, the Bank maintained credit facilities with the FHLB of Des Moines for ~~$662.4~~$826.8 million and credit facilities with the Federal Reserve Bank ~~of San Francisco~~ for ~~$50.6~~$45.2 million. The Company had no FHLB advances outstanding ~~of $117.4 million and $79.6 million~~ at September 30, ~~2017~~2018 and $92.5 million at December 31, ~~2016, respectively.~~2017. The average cost of the FHLB advances during the nine months ended September 30, 2018 and 2017 was 1.98% and 1.09%., respectively. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of September 30, ~~2017.~~2018. There were no federal funds purchased as of September 30, ~~2017~~2018 or December 31, ~~2016.~~2017.

We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2017, cash and cash equivalents totaled $111.3 million, or 2.7% of total assets. The fair value of investment securities available for sale totaled $800.1 million at September 30, 2017 of which $257.0 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $543.1 million, or 13.4%, of total assets at September 30, 2017. The fair value of investment securities available for sale with maturities of one year or less were $6.6 million, or 0.2%, of total assets at September 30, 2017.

Liquidity and Cash Flows

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment

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securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.

Heritage Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established credit facilities and lines with correspondent banks or sale of investment securities.

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Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations. At September 30, ~~2017,~~2018, the Company (on an unconsolidated basis) had cash and cash equivalents of $14.5 million.

We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2018, cash and cash equivalents totaled $170.1 million, or 3.2% of total assets. The fair value of investment securities available for sale totaled $920.7 million at September 30, 2018, of which $255.2 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $665.5 million, or 12.6%, of total assets at September 30, 2018. The fair value of investment securities available for sale with ~~no stated~~ maturities of ~~$11.6 million.~~one year or less were $20.7 million, or 0.4%, of total assets at September 30, 2018.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was ~~$53.8~~$55.4 million for the nine months ended September 30, ~~2017,~~2018, and primarily consisted of net income of $31.8 million, net proceeds from origination and sale of loans held for sale of $2.2 million and net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities of $8.3$36.4 million. During the nine months ended September 30, ~~2017,~~2018, net cash used in investing activities was ~~$169.9~~$42.8 million, which consisted primarily of net loan originations of ~~$178.8~~$93.0 million, ~~investment in low income housing tax credit partnerships of $8.5 million and~~ net ~~proceeds from purchase and sale~~purchases of investment securities ~~available~~ for sale of ~~$3.4~~$40.9 million, and purchases of premises and equipment of $21.5 million, offset partially by net cash received from acquisitions of $106.0 million. Net cash provided by financing activities was ~~$123.6~~$54.5 million for the nine months ended September 30, ~~2017,~~2018, and primarily consisted of a net increase in deposits of ~~$91.2 million, net FHLB advances of $37.8 million and a net increase in securities sold under agreements to repurchase of $6.6 million, offset partially by cash dividends on common stock of $11.4~~$180.5 million during the ~~period.~~period, partially offset by net FHLB repayments of $108.5 million and dividends paid of $15.8 million

Capital and Capital Requirements

Stockholders’ equity at September 30, ~~2017~~2018 was ~~$507.6~~$746.1 million compared ~~with $481.8~~to $508.3 million at December 31, ~~2016. During~~2017. The changes to stockholders' equity during the nine months ended September 30, 2017, the Company realized net income of $31.8 million, declared cash dividends of $11.4 million, recorded other comprehensive income of $4.4 million, recognized stock-based compensation expense of $1.6 million, and recorded a net decrease to common stock due to common stock repurchases and exercises of stock options, net of tax, of $515,000.

Pursuant to minimum capital requirements of the FDIC effective on January 1, 2015, all FDIC-insured financial institutions, including Heritage Bank, are required to maintain a minimum common equity Tier 1 risk-based capital to risk-weighted assets ratio of 4.5%, a minimum Tier 1 leverage ratio to average assets of 4.0% and minimum risk-based capital ratios of Tier 1 capital to risk-weighted assets and total capital to risk-weighted assets of 6.0% and 8.0%, respectively.

~~As of September 30, 2017 and December 31, 2016, the most recent regulatory notifications categorized Heritage Bank~~2018 is as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s categories. The following table provides our capital requirements and actual results.

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follows:

Minimum Requirements Well-Capitalized Requirements Actual
(Dollars in thousands)
As of September 30, 2017:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 151,086
4.5 % N/A
N/A
$ 383,546
11.4 %
Tier 1 leverage capital to average assets 155,761
4.0
N/A
N/A
403,444
10.4
Tier 1 capital to risk-weighted assets 201,448
6.0
N/A
N/A
403,444
12.0
Total capital to risk-weighted assets 268,598
8.0
N/A
N/A
435,119
13.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 150,874
4.5
$ 217,929
6.5 % 388,852
11.6
Tier 1 leverage capital to average assets 155,582
4.0
194,478
5.0
388,852
10.0
Tier 1 capital to risk-weighted assets 201,165
6.0
268,221
8.0
388,852
11.6
Total capital to risk-weighted assets 268,221
8.0
335,276
10.0
420,422
12.5

As of December 31, 2016:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 142,688
4.5 % N/A
N/A
$ 362,350
11.4 %
Tier 1 leverage capital to average assets 148,144
4.0
N/A
N/A
381,989
10.3
Tier 1 capital to risk-weighted assets 190,250
6.0
N/A
N/A
381,989
12.0
Total capital to risk-weighted assets 253,667
8.0
N/A
N/A
413,320
13.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 142,573
4.5
$ 205,938
6.5 % 369,915
11.7
Tier 1 leverage capital to average assets 148,024
4.0
185,030
5.0
369,915
10.0
Tier 1 capital to risk-weighted assets 190,097
6.0
253,462
8.0
369,915
11.7
Total capital to risk-weighted assets 253,462
8.0
316,828
10.0
401,168
12.7



	Nine Months Ended
	September 30, 2018
	(In Thousands)
Balance, beginning of period	$	508,305
Common stock issued in the Premier and Puget Mergers	230,043
Net income	36,448
Dividends declared	(15,796		)
Accumulated other comprehensive loss	(13,299		)
Other	432
Balance, end of period	$	746,133

Although new capital requirements were effective on January 1, 2015, certain provisions of the new rule will be phased-in from the effective date through 2019, including, among others, a new capital conservation buffer requirement, which requires financial institutions to maintain a common equity capital ratio more than 2.5% above the required minimum levels in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments based on percentages of eligible retained income that could be utilized for such actions. The new capital conservation buffer requirement began to be phased-in on January 1, 2016 at 0.625% of risk-weighted assets and will continue to increase by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019. At September 30, 2017, the capital conservation buffer was 5.07% and 4.65% for the Company ~~and the Bank, respectively, and the minimum conservation buffer requirement was 1.25%.~~

~~Quarterly, the Company reviews the potential payment of~~has historically paid cash dividends to its common shareholders. ~~The timing and amount~~Payments of future cash dividends, ~~paid~~if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ~~common stock depends on the Company’s earnings, capital requirements, financial condition~~ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On October ~~25, 2017,~~24, 2018, the Company’s Board of Directors declared a regular dividend of ~~$0.13~~$0.17 per common share and a special dividend in the amount of $0.10 per common share which are both payable on November ~~22, 2017~~21, 2018 to shareholders of record on November ~~8, 2017.~~7, 2018.

The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements and operations. Management believes as of September 30, 2018, the Company and the Bank meet all capital adequacy requirements to which they are subject.

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As of September 30, 2018 and December 31, 2017, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories.



	Minimum Requirements				Well-Capitalized Requirements				Actual
	(Dollars in thousands)
As of September 30, 2018:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	198,182	4.5	%	N/A		N/A		$	501,520	11.4	%
Tier 1 leverage capital to average assets	200,197		4.0		N/A		N/A		521,749		10.4
Tier 1 capital to risk-weighted assets	264,243		6.0		N/A		N/A		521,749		11.8
Total capital to risk-weighted assets	352,324		8.0		N/A		N/A		556,530		12.6
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	197,997		4.5		$	285,996	6.5	%	504,538		11.5
Tier 1 leverage capital to average assets	201,185		4.0		251,481		5.0		504,538		10.0
Tier 1 capital to risk-weighted assets	263,996		6.0		351,995		8.0		504,538		11.5
Total capital to risk-weighted assets	351,995		8.0		439,993		10.0		539,319		12.3

As of December 31, 2017:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	154,522	4.5	%	N/A		N/A		$	386,689	11.3	%
Tier 1 leverage capital to average assets	159,494		4.0		N/A		N/A		406,687		10.2
Tier 1 capital to risk-weighted assets	206,029		6.0		N/A		N/A		406,687		11.8
Total capital to risk-weighted assets	274,706		8.0		N/A		N/A		439,044		12.8
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	154,400		4.5		$	223,023	6.5	%	391,092		11.4
Tier 1 leverage capital to average assets	159,300		4.0		199,125		5.0		391,092		9.8
Tier 1 capital to risk-weighted assets	205,867		6.0		274,490		8.0		391,092		11.4
Total capital to risk-weighted assets	274,490		8.0		343,112		10.0		423,348		12.3

Effective January 1, 2015 (with some changes transitioned into full effectiveness over two to four years), the Company became subject to new capital adequacy requirements approved by the Federal Reserve and the FDIC that implement the revised standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of the Dodd-Frank Act.

Under the new capital requirements both the Company and the Bank are required to have a common equity Tier 1 capital ratio of 4.5%. In addition, both the Company and the Bank are required to have a Tier 1 leverage ratio of 4.0%, a Tier 1 risk-based ratio of 6.0% and a total risk-based ratio of 8.0%. Both the Company and the Bank are required to establish a “conservation buffer”, consisting of common equity Tier 1 capital of more than 2.5% above the minimum risk-based capital ratios. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. An institution that does not meet the conservation buffer will be subject to restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. The capital conservation buffer requirement began to be phased-in on January 1, 2016 when more than 0.625% of risk-weighted assets was required, and increases by 0.625% on each subsequent January 1, until it is fully phased-in on January 1, 2019. Certain calculations under the rules will

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also have phase-in periods. At September 30, 2018, the capital conservation buffer was 4.64% and 4.26% for the Company and the Bank, respectively.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our Annual Report on Form 10-K for the year ended December 31, ~~2016.~~2017.

~~We do not~~Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase ~~high-risk~~high risk derivative instruments. Moreover, neither we, ~~have no material~~nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of September 30, ~~2017~~2018 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended September 30, ~~2017,~~2018, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company does not expect that its internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

~~Heritage~~We, and ~~Heritage~~our Bank, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

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ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors set forth in Part I. Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, ~~2016.~~

~~Table of Contents~~

2017.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(a) Not applicable.

(b) Not applicable.

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016 Plan Total (1)
Eleventh Plan
Repurchased shares —
38,000
—
138,000
579,996
Stock repurchase average share price $ —
$ 17.46
$ —
$ 17.16
$ 16.76


~~(1)~~	~~Represents shares repurchased and average price per share paid during the duration of the plan.~~



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	368		344		53,188		27,711
Stock repurchase to pay withholding taxes average share price	$	36.34	$	25.80	$	31.99	$	24.61

⁽¹⁾During the ~~three and~~ nine months ended September 30, ~~2017,~~2018, 26,741 of the ~~Company~~shares repurchased ~~344 and 27,711 shares~~related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock atshares with an average share price ~~per share~~ of ~~$25.80 and $24.61 to pay withholding taxes on~~$31.80 under the ~~vesting~~terms of ~~restricted stock that vested during~~ the respective periods. During the three and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.merger agreement.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended September 30, ~~2017.~~2018.

Period
Total Number
of Shares
Purchased(1)

Average Price
Paid Per
Share(1)

Total Number of Shares Purchased as
Part of Publicly
Announced Plans or Programs

Maximum Number
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
July 1, 2017— July 31, 2017 —
$ —
7,893,389
935,034
August 1, 2017— August 31, 2017 —
—
7,893,389
935,034
September 1, 2017— September 30, 2017 344
25.80
7,893,389
935,034
Total 344
$ 25.80
7,893,389
935,034



Period	Total Number of Shares Purchased⁽¹⁾	Average Price Paid Per Share⁽¹⁾		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs ⁽²⁾	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
July 1, 2018— July 31, 2018	—	$	—	7,893,389	935,034
August 1, 2018— August 31, 2018	—	—		7,893,389	935,034
September 1, 2018— September 30, 2018	368	36.64		7,893,389	935,034
Total	368	$	36.64


~~(1)~~	~~All of the common shares repurchased by the Company between July 1, 2017 and September 30, 2017 were shares of restricted stock that represented the cancellation of stock to pay withholding taxes.~~

⁽¹⁾ All of the common shares repurchased by the Company between July 1, 2018 and September 30, 2018 represented the cancellation of stock to pay withholding taxes on vested restricted stock awards or units.

⁽²⁾ Represents cumulative life-to-date shares repurchased.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

~~None~~

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None

ITEM 6. EXHIBITS

Incorporated by Reference

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

2.5

Agreement and Plan of Merger with Puget Sound Bank

8-K

2.1

7/27/17

Agreement and Plan of Merger with Puget Sound Bancorp, Inc

8-K

2.1

7/27/2017

2.6

Agreement and Plan of Merger with Premier Commercial Bancorp, Inc

8-K

2.1

3/9/2018

31.1

Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

31.2

Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

32.1

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

101

The following financial information from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017 is formatted in XBRL: (i) the Unaudited Condensed Consolidated Statements of Financial Condition, (ii) the Unaudited Condensed Consolidated Statements of Income, (iii) the Unaudited Condensed Consolidated Statements Comprehensive Income, (iv) the Unaudited Condensed Consolidated Statements of Stockholders’ Equity, (v) the Unaudited Condensed Consolidated Statements of Cash Flows and (vi) the Unaudited Notes to Condensed Consolidated Financial Statements.

101.INS

XBRL Instance Document ⁽¹⁾

101.SCH

XBRL Taxonomy Extension Schema Document ⁽¹⁾

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document ⁽¹⁾

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document ⁽¹⁾

101.LAB

XBRL Taxonomy Extension Label Linkbase Document ⁽¹⁾

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document ⁽¹⁾

⁽¹⁾ Filed herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		HERITAGE FINANCIAL CORPORATION

Date:
November ~~9, 2017~~6, 2018		/S/ BRIAN L. VANCE
		Brian L. Vance
		~~President and~~ Chief Executive Officer
		~~(Duly Authorized Officer)~~

Date:
November ~~9, 2017~~6, 2018		/S/ DONALD J. HINSON
		Donald J. Hinson
		Executive Vice President and Chief Financial Officer
		~~(Principal Financial and Accounting Officer)~~

7078



	Three Months Ended September 30, 2017 ⁽¹⁾			Nine Months Ended September 30, 2017 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	1,557		$	(2,606	)
Other comprehensive income before reclassification	289			4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(28		)	(104		)
Net current period other comprehensive income	261			4,424
Balance of AOCI at the end of period	$	1,818		$	1,818



	Three Months Ended September 30, 2016 ⁽¹⁾			Nine Months Ended September 30, 2016 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	12,343		$	2,559
Other comprehensive income before reclassification	(1,055		)	9,223
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income	(224		)	(718		)
Net current period other comprehensive income	(1,279		)	8,505
Balance of AOCI at the end of period	$	11,064		$	11,064



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015	264,521		$	15.92
Granted	119,939		17.53
Vested	(111,357	)	15.62
Forfeited	(9,216	)	16.57
Nonvested at September 30, 2016	263,887		$	16.76

Nonvested at December 31, 2016	261,296		$	16.80
Granted	—		—
Vested	(107,202	)	16.49
Forfeited	(10,418	)	16.80
Nonvested at September 30, 2017	143,676		$	17.02



	Basis⁽¹⁾		Fair Value at December 31, 2016
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended September 30, 2016			Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2016
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	205	$	200	$	—	$	—	$	200	$	24		$	25
Owner-occupied commercial real estate	780		603		—		—		603		23			(2		)
Total commercial business	985		803		—		—		803		47			23
Real estate construction and land development:
One-to-four family residential	828		822		—		—		822		(13		)	(26		)
Total real estate construction and land development	828		822		—		—		822		(13		)	(26		)
Consumer	16		9		—		—		9		—			—
Total assets measured at fair value on a nonrecurring basis	$	1,829	$	1,634	$	—	$	—	$	1,634	$	34		$	(3	)



Period	Total Number of Shares Purchased(1)	Average Price Paid Per Share(1)		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
July 1, 2017— July 31, 2017	—	$	—	7,893,389	935,034
August 1, 2017— August 31, 2017	—	—		7,893,389	935,034
September 1, 2017— September 30, 2017	344	25.80		7,893,389	935,034
Total	344	$	25.80	7,893,389	935,034